GENERAL PRINCIPLES OF

CREDIT ANALYSIS
Introduction:
The credit risk of a bond includes:
1. The risk that the issuer will default on its obligation and
2. The risk that the bonds value will decline and/or the bonds price performance will be worse
than that of other bonds against which the investor is compared because either (a) the market
requires a higher spread due to a perceived increase in the risk that the issuer will default or (b)
companies that assign ratings to bonds will lower a bonds rating.
The first risk is referred to as default risk. The second risk is labeled based on the reason for the
adverse or inferior performance. The risk attributable to an increase in the spread, or more
specifically the credit spread, is referred to as credit spread risk; the risk attributable to a
lowering of the credit rating (i.e., a downgrading) is referred to as downgrade risk. Credit
analysis of any entity-a corporation, a municipality, or a sovereign government-involves the
analysis of a multitude of quantitative and qualitative factors over the past, present, and future.
There are four general approaches to gauging credit risk:
I.
II.
III.
IV.

Credit ratings
Traditional credit analysis
Credit scoring models
Credit risk models

Our primary focus is on the credit analysis of corporate bonds.

I.
CREDIT RATINGS:
A credit rating is a formal opinion given by a specialized company of the default risk faced by
investing in a particular issue of debt securities. The specialized companies that provide credit
ratings are referred to as rating agencies.
Rating Process, Surveillance, and Review:

The rating process begins when a rating agency receives a formal request from an entity planning
to issue a bond in which it seeks a rating for the bond issue (i.e., an issue specific credit
rating). The cost associated with obtaining a credit rating is paid by the entity making the
request for a rating. The request for a rating is made because without one, it would be difficult
for the entity to issue a bond. The rating assigned applies to the specific bond to be issued, not to
the entity requesting the rating. A rating agency may also be requested to provide a rating for a
company that has no public debt outstanding (i.e., an issuer credit rating). This is done for
companies that are parties in derivative transactions, such as swaps, so that market participants
can assess counterparty risk.

Once a credit rating is assigned to a corporate debt obligation, a rating agency monitors the credit
quality of the issuer and can reassign a different credit rating to its bonds. An upgrade occurs
when there is an improvement in the credit quality of an issue; a downgrade occurs when there
is a deterioration in the credit quality of an issue. As noted earlier, downgrade risk is the risk that
an issue will be downgraded. Typically, before an issues rating is changed, the rating agency will
announce in advance that it is reviewing the issue with the potential for upgrade or downgrade.
The issue in such cases is said to be on rating watch or credit watch. In the announcement,
the rating agency will state the direction of the potential change in ratingupgrade or
downgrade. Typically, a decision will be made within three months. In addition, rating agencies
will issue rating outlooks. A rating outlook is a projection of whether an issue in the long term
(from six months to two years) is likely to be upgraded, downgraded, or maintains its current
rating. Rating agencies designate a rating outlook as either positive (i.e., likely to be upgraded),
negative (i.e., likely to be downgraded), or stable (i.e., likely to be no change in the rating).
Gauging Default Risk and Downgrade Risk:

The information available to investors from rating agencies about credit risk are:
(1) Ratings,
(2) Rating watches or credit watches, and
(3) Rating outlooks. Moreover, periodic studies by the rating agencies provide information to
investors about credit risk. Below we describe how the information provided by rating agencies
can be used to gauge two forms of credit risk: default risk and downgrade risk. For long-term
debt obligations, a credit rating is a forward-looking assessment of(1) The probability of default and
(2) The relative magnitude of the loss should a default occur.
For short-term debt obligations (i.e., obligations with initial maturities of one year or less), a
credit rating is a forward-looking assessment of the probability of default. Consequently, credit
ratings are the rating agencies assessment of the default risk associated with a bond issue.
Periodic studies by rating agencies provide information about two aspects of default risk-default
rates and default loss rates. First, rating agencies study and make available to investors the
percentage of bonds of a given rating at the beginning of a period that have defaulted at the end
of the period. This percentage is referred to as the default rate. For example, a rating agency
might report that the one-year default rate for triple B rated bonds is 1.8%. These studies have
shown that the lower the credit rating, the higher the default rate. Rating agency studies also
show default loss rates by rating and other characteristics of the issue (e.g., level of seniority and
industry). A default loss rate is a measure of the magnitude of the potential of the loss should a
default occur. A study by Moodys found that for a corporate bond, its ratings combined with its
rating watches and rating outlook status provides a better gauge for default risk than using the
ratings alone. The authors of the study looked at one-year and three-year default rates from 1996
through 2003 for senior unsecured rated bonds and within each rating by rating watch (watch
upgrade and watch downgrade) and rating outlook status (positive, stable, and negative).

Moodys makes the following suggestion as to how an analyst can combine the information
contained in rating watches and outlook rating status to adjust the senior unsecured rating of a
corporate bond:
For issues on
downgrade watch
upgrade watch
negative outlook
stable outlook
positive outlook

Suggestion
reduce current rating by two rating notches
increase current rating by two rating notches
reduce current rating by one rating notch
keep current rating
increase current rating by one rating notch

Of course, portfolio managers may elect to develop their own system for adjusting the current
rating of a bond based on their assessment of the findings of the study by Moodys. What is
essential, however, is that in assessing the default risk when using credit ratings, portfolio
managers should take into consideration rating watches and rating outlook status.
While the discussion above has focused on default risk, other studies by rating agencies also
provide information. A rating transition table shows the percentage of issues of each rating at the
beginning of a period that was downgraded or upgraded by the end of the time period.
Consequently, by looking at the percentage of downgrades for a given rating, an estimate can be
obtained of the probability of a downgrade and this can serve as a measure of downgrade risk.

Traditional Credit Analysis:

In traditional credit analysis, the analyst considers the four Cs of credit:

Capacity is the ability of an issuer to repay its obligations

Collateral is looked at not only in the traditional sense of assets pledged to secure the
debt, but also to the quality and value of those unpledged assets controlled by the issuer.
Covenants are the terms and conditions of the lending agreement
Character includes ethical reputation, business qualifications, operating record of the
board of directors and management.

1. Analysis of the Capacity to Pay:

A corporation will generate the funds to service its debt from its cash flow. Cash flow consists
from revenues and costs of operations. Factors examined by analyst are:
1. Industry trends
2. The regulatory environment
3. Basic operating and competitive position
4. Financial position and sources of liquidity
5. Company structure (including structural subordination and priority of claim)
6. Parent company support agreements
7. Special event risk
In the analysis of an issuers ability to pay, the analyst will analyze the issuers financial
statements (income statement, balance sheet, and statement of cash flows), project future
financial statements based on certain assumptions, and compute various measures.

The important factors for Capacity of the industry are:

Industry Structure: Porters Five Forces, PESTLE Analysis.
Industry Fundamental: Industry cyclicality, Industry Growth Prospect, Industry
Published Statistic
Company Fundamental: Competitive Position, Operating History, Managements
strategy , execution Ratios and ratio analysis
In the analysis of an issuers ability to pay, the analyst will analyze the issuers financial
statements (income statement, balance sheet, and statement of cash flows), project future
financial statements based on certain assumptions, and compute various measures. These
measures include traditional ratio measures and cash flow measures.
Traditional Ratios:
Traditional ratios to evaluate the ability of an issuer to meet its obligations include:

Return on Stockholders Equity: Equity analysts use the DuPont formula

(explained in textbooks on equity analysis) to assess the determinants of a
companys earnings per share.
Return on Total Assets:
Profit Margin: Profitability ratios are utilized to explore the underlying causes of
a change in the companys earnings.
Asset Turnover
Debt and Coverage Analysis:
Short-term solvency ratios: Short-term solvency ratios are used to judge the
adequacy of liquid assets for meeting short-term obligations as they come due.
Current Assets
current ratio = Current Liabilities

Acid Test Ratio =

Current AssetInventories
Current Liabilities

Capitalization Ratio: Credit analysts also calculate capitalization ratios to

determine the extent to which the corporation is using financial leverage.
Long-term debt to capitalization =
longterm debt
longterm debt+ shareholders equity including minority interest

Total debt to capitalization =

current liabilities+ longterm debt

long term debt+ current liabilities+ shareholders equity including minority interest

Coverage Tests: Coverage ratios are used to test the adequacy of cash flows
generated through earnings for purposes of meeting debt and lease obligations.
The four most commonly used coverage ratios are:

EBIT interest coverage ratio

EBITDA interest coverage ratio
Funds From Operations/Total Debt Ratio
Free Operating Cash Flow/Total Debt Ratio

2. Analysis of Collateral :
The assets offered as backup or security for the debt. A corporate debt obligation can be secured
or unsecured. We also need to consider other unpledged assets controlled by the debt issuer. For
Example, intangible assets like brand name, patents etc. Quality and value of assets pledged to
secure debts. Issue to consider for collateral:
o
o
o
o

Intangible Assets.
Depreciation
Equity market Capitalization
Human and intellectual capital

3. Analysis of Covenants:
Covenants are created to protect interest of bondholders. Failure to comply covenants results in
Technical Default. There are two types of covenants:

Affirmative covenants: require debtor to do certain things. For example pay

coupons, Principals on time etc. Affirmative covenant reduce uncertainty of the
bondholders.
Negative covenants: prohibit debtor from doing certain things (ie. No additional
borrowing, limitation on dividend payment, stock repurchase) Too much and too
stringent negative covenants may reduce the issuers ability to service the debt.

4. Analysis of Character:
Character of management is the foundation of sound credit. This includes the ethical reputation
and the business qualifications and track record of the management and the Board of Directors
etc. In particular the better the firm's corporate governance structure, the better its credit rating,
the lower its bond yields, and vice verse. Following are factors that are considered for judging
the character of a corporation:
Strategic direction,
Financial philosophy,
Conservatism,
Track record,
Succession planning, and
Control systems

Corporate Governance
Corporate Governance is the framework of rules and practices by which a board of directors
ensures accountability, fairness, and transparency in a company's relationship with its all
stakeholders (financiers, customers, management, employees, government, and the community.

The bylaws are the rules of governance for the corporation. The bylaws define the rights and
obligations of officers, members of the board of directors, and shareholders.).

Agency problem
A conflict of interest inherent in any relationship where one party is expected to act in another's
best interests. The problem is that the agent who is supposed to make the decisions that would
best serve the principal is naturally motivated by self-interest, and the agent's own best interests
may differ from the principal's best interests. The agency problem is also known as the
"principalagent problem."

Stakeholders and Corporate Governance

The various groups of persons that depend on a firm are referred to as its stakeholders; they all
have some stake in the outcomes of the firm. The effects of a firms actions on others are referred
to as externalities. Pollution is an important example. The firm may try to use its efforts at
pollution control to enhance its reputation in the hope that this will lead to a sales increase large
enough to make up for the cost of reducing pollution.

Mitigating the Agency Problem: Standard and Codes of Best Practices for
Corporate Governance:
There are three ways that shareholders can reduce the likelihood that management will act in its
self interest. First, the compensation of the manager can be tied to the price performance of the
firm. Second, managers can be granted a significant equity interest in the company. While an
interesting solution, in practice most CEOs and boards Finally, the firms internal corporate
control systems can provide a means for effectively monitoring the performance and decisionmaking behavior of management.
The standards of best practice that have become widely accepted as a benchmark are those set
forth by the Organization of Economic Cooperation and Development (OECD) in 1999. The
OECD Principles of Corporate Governance cover:

The basic rights of shareholders

Equitable treatment of shareholders
The role of stakeholders
Disclosure and transparency
The role of the board of directors.

Corporate Governance and Bond Ratings:

Several studies have investigated the impact of corporate governance on stockholder returns. A
study by Bhojraj and Sengupta investigates this relationship using a large sample of 1,001
industrial bonds for the period 19911996.
They note that a firms likelihood of default can be decomposed into two risks, information risk
and agency risk. Information risk is the risk that the available information for evaluating default
risk is not credible. Agency risk is the risk that management will make decisions in its own self
interest,thereby reducing firm value. Bhojraj and Sengupta argue that if corporate governance

mechanisms reduce agency risk and information risk, the result is that strong corporate
governance should be associated with superior bond ratings and therefore lower yields. Bhojraj
and Sengupta conclude that their findings are consistent with the view that institutional owners
and outside directors play an active role in reducing management opportunism and promoting
firm value.

6. Corporate Governance Ratings:

Several firms have developed services that assess corporate governance. One type of service
provides confidential assessment of the relative strength of a firms corporate governance
practices. The second is a service that rates (or scores) the corporate governance mechanisms of
companies. Generally, these ratings are made public at the option of the company requesting an
evaluation.
Firms that provide corporate governance ratings for companies fall into two categories. The first
are those that provide ratings for companies within a country. Examples of countries where firms
have produced or plan to produce corporate governance ratings are Australia, Brazil, Greece,
India, Malaysia, Philippines, Russia, South Korea, and Thailand.30 The second category includes
firms that rate across country borders. Examples of firms that fall into this category are Standard
& Poors, Governance Metrics International, The Corporate Library, and Deminor.
Standard & Poors produces a Corporate Governance Score which, at the option of the company,
may be disclosed to the public. The score or rating is based on a review of both publicly
available information, interviews with senior management and directors, and confidential
information that S&P may have available from its credit rating of the corporations debt.
S&P believes that its Corporate Governance Score helps companies in the following ways:
Benchmark their current governance practices against global best practices
Communicate both the substance and form of their governance practices to investors,
insurers, creditors, customers, regulators, employees, and other stakeholders
Enhance the investor relations process when used as part of a program designed to
highlight governance effectiveness to both potential and current investors, thus
differentiating the company from its competitors.
The score is based on four key elements evaluated by S&P:
1.
2.
3.
4.

Ownership structure and external influences

Shareholder rights and stakeholder relations
Transparency, disclosure and audit
Board structure and effectiveness

Based on the S&Ps analysis of the four key elements listed above, its assessment of the
companys corporate governance practices and policies and how its policies serve shareholders
and other stakeholders is reflected in the Corporate Governance Score. The score ranges from 10
(the highest score) to 1 (the lowest score).

Special Considerations for High-Yield Corporate Bonds:

There are some unique factors that should be considered in the analysis of high-yield bonds. We
will discuss the following:
o Analysis of debt structure
o Analysis of corporate structure
o Analysis of covenants

1. Analysis of Debt Structure:

Cornish explained why it was necessary for an analyst to examine a high-yield issuers debt
structure. At the time of his presentation, new types of bonds were being introduced into the
high-yield market such as deferred coupon bonds. He noted that the typical debt structure of a
high-yield issuer includes:

Bank debt
Brokers loans or bridge loans
Reset notes
Senior debt
Senior subordinated debt
Subordinated debt (payment in kind bonds)

2. Analysis of Corporate Structure:

High-yield issuers usually have a holding company structure. The assets to pay creditors of the
holding company will come from the operating subsidiaries.. Specifically, the analyst must
understand the corporate structure in order to assess how cash will be passed between
subsidiaries and the parent company and among the subsidiaries. The corporate structure may be
so complex that the payment structure can be confusing.

3. Analysis of Covenants:
While an analyst should of course consider covenants when evaluating any bond issue
(investment grade or high yield), it is particularly important for the analysis of high-yield issuers.
4) Equity Analysis Approach: Historically, the return on high-yield bonds has been greater than
that of high-grade corporate bonds but less than that of common stocks. The risk (as measured in
terms of the standard deviation of returns) has been greater than the risk of high-grade bonds but
less than that of common stock. Moreover, high-yield bond returns have been found to be more
highly correlated to equity returns than to investment grade bond returns.
Credit Analysis of Non-Corporate Bonds: In this section we will look at the key factors
analyzed in assessing the credit of the following non-corporate bonds:

1)

Asset-backed securities and non-agency mortgage-backedsecurities

Municipalbonds
Sovereign bonds
Asset-Backed Securities and Non-Agency Mortgage-Backed Securities: Assetbacked
securities and non-agency mortgage-backed securities expose investors to credit risk. The
three nationally recognized statistical rating organizations rate asset-backed securities.
We begin with the factors considered by rating agencies in assigning ratings to asset-

backed securities. Then we will discuss how the agencies differ with respect to rating
asset-backed securities versus corporate bonds.
A) Factors Considered by Rating Agencies In analyzing credit risk, the rating
companies focus on:
I.
Creditquality of the collateral
II.
Quality of the seller/servicer
III.
Cash flow stress and payment structure, and
IV. Legal structure. We discuss each below:
Credit Quality of the Collateral: Analysis of the credit quality of the collateral depends on the
asset type. The rating companies will look at the underlying borrowers ability to pay and the
borrowers equity in the asset. The latter will be a key determinant as to whether the underlying
borrower will default or sell the asset and pay off a loan.
The concentration of loans is examined. The underlying principle of asset securitization is that
the large number of borrowers in a pool will reduce the credit risk via diversification. If there are
a few borrowers in the pool that are significant in size relative to the entire pool balance, this
diversification benefit can be lost, resulting in a higher level of default risk. This risk is called
concentration risk.
Quality of the Seller/Servicer: All loans must be serviced. Servicing involves collecting
payments from borrowers, notifying borrowers who may be delinquent, and, when necessary,
recovering and disposing of the collateral if the borrower does not make loan repayments by a
specified time. These responsibilities are fulfilled by a third-party to an asset-backed securities
transaction called a servicer. The servicer may be the originator of the loans used as the
collateral.
Cash Flow Stress and Payment Structure: As explained asset-backed securities; the waterfall
describes how the cash flow (i.e., interest and principal payments) from the collateral will be
distributed to pay trustee fees, servicing fees, other administrative fees, and interest and principal
to the bondholders in the structure. In determining a rating for bond class, the process begins
with an analysis of the cash flow from the collateral under different assumptions about losses and
delinquencies and economic scenarios established by the rating agency.
Legal Structure: A corporation using structured financing seeks a rating on the securities it
issues that is higher than its own corporate bond rating. If that is not possible, the corporation
seeking funds would be better off simply issuing a corporate bond.
B) Corporate Bond versus Asset-Backed SecuritiesCredit Analysis:Lets look at how the
rating of an asset-backed security differs from that of a corporate bond issue. To
understand the difference, it is important to appreciate how the cash flow that must be
generated differs for a corporate bond issue and a securitization transaction from which
the asset-backed securities are created.
2) Municipal Bonds Earlier we discussed municipal bonds available in the United States
tax-backed debt and revenue bonds. However, municipal governments in other countries

are making greater use of bonds with similar structures to raise funds. Below we discuss
the factors that should be considered in assessing the credit risk of an issue.
A) Tax-Backed Debt: In assessing the credit risk of tax-backed debt, there are four basic
categories that should be considered. The first category includes information on the
issuers debt structure to determine the overall debt burden. The second category
relates to theissuers ability and political discipline to maintain sound budgetary
policy. The third category involves determining the specific local taxes and
intergovernmental revenues available to the issuer, as well as obtaining historical
information both on tax collection rates, which are important when looking at
property tax levies, and on the dependence of local budgets on specific revenue
sources.
B) Revenue Bonds: Revenue bonds are issued for either project or enterprise financings
where the bond issuers pledge to the bondholders the revenues generated by the
operating projects financed, or for general public-purpose financings in which the
issuers pledge to the bondholders the tax and revenue resources that were previously
part of the general fund. While there are numerous security structures for revenue
bonds, the underlying principle in assessing an issuers credit worthiness is whether
the project being financed will generate sufficient cash flows to satisfy the obligations
due bondholders. Consequently, the analysis of revenue bonds is similar to the
analysis of corporate bonds.
The limits of the basic security,
The flow-of-funds structure,
The rate, or user-charge, covenant,
The priority-of-revenue claims,
The additional-bonds tests, and
Other relevant covenants.
i.
Limits of the Basic Security: The trust indenture and legal opinion should explain
the nature of the revenues for the bonds and how they realistically may be limited by
federal, state, and local laws and procedures. The importance of this is that while
most revenue bonds are structured and appear to be supported by identifiable revenue
streams, those revenues sometimes can be negatively affected directly by other levels
of government.
ii.
Flow of Funds Structure for Revenue Bonds: For a revenue bond, the revenue of
the enterprise is pledged to service the debt of the issue. The details of how revenue
received by the enterprise will be disbursed are set forth in the trust indenture.
Typically, the flow of funds for a revenue bond is as follows. First, all revenues from
the enterprise are put into a revenue fund. It is from the revenue fund that
disbursements for expenses are made to the following funds: operation and
maintenance fund, sinking fund, debt service reserve fund, renewal and replacement
fund, reserve maintenance fund, and surplus fund.

iii.

Rate, or User-Charge, Covenants: There are various restrictive covenants included

in the trust indenture for a revenue bond to protect the bondholders. A rate covenant
(or user charge covenant) dictates how charges will be set on the product or service
sold by the enterprise. The covenant could specify that the minimum charges be set so
as to satisfy both expenses and debt servicing, or to yield a higher rate to provide for a
certain amount of reserves.
iv.
Priority-of-Revenue Claims: The legal opinion as summarized in the official
statement should clearly indicate whether or not others can legally tap the revenue of
the issuer even before they start passing through the issuers flow-of-funds structure
v.
Additional-Bonds Test: An additional-bonds test covenant indicates whether
additional bonds with the same lien (i.e., claim against property) may be issued. If
additional bonds with the same lien may be issued, the conditions that must first be
satisfied are specified. Other covenants specify that the facility may not be sold, the
amount of insurance to be maintained, requirements for recordkeeping and for the
auditing of the enterprises financial statements by an independent accounting firm,
and requirements for maintaining the facilities in good order.
vi.
Other Relevant Covenants: There are other relevant covenants for the bondholders
protection that the trust indenture and legal opinion should cover. These usually
include pledges by the issuer of the bonds to have insurance on the project, to have
accounting records of the issuer annually audited by an outside certified public
accountant, to have outside engineers annually review the condition of the facility,
and to keep the facility operating for the life of the bonds.
C) Corporate versus Municipal Bond Credit Analysis: The credit analysis of
municipal bonds involves the same factors and quantitative measures as in corporate
credit analysis. For tax-backed debt, the analysis of the character of the public
officials is the same as that of the analysis of the character of management for a
corporate bond. The analysis of the ability to pay in the case of tax-backed debt
involves looking at the ability of the issuing entity to generate taxes and fees. As a
corporate analyst would look at the composition of the revenues and profits by
product line for a corporation, the municipal analyst will look at employment,
industry, and real estate valuation trends needed to generate taxes and fees. The credit
analysis of municipal revenue bonds is identical to that of a corporate bond analysis.
Effectively, the enterprise issuing a municipal revenue bond must generate cash flow
from operations to satisfy the bond payments. The covenants that are unique to a
municipal revenue bond and impact the credit analysis are the rate covenants and the
priority-of-revenue covenants. The former dictates how the user charges will be set to
meet the bond obligations.
4) Equity Analysis Approach: Historically, the return on high-yield bonds has been greater than
that of high-grade corporate bonds but less than that of common stocks. The risk (as measured in
terms of the standard deviation of returns) has been greater than the risk of high-grade bonds but

less than that of common stock. Moreover, high-yield bond returns have been found to be more
highly correlated to equity returns than to investment grade bond returns.
Credit Analysis of Non-Corporate Bonds: In this section we will look at the key factors
analyzed in assessing the credit of the following non-corporate bonds:

3)

Asset-backed securities and non-agency mortgage-backedsecurities

Municipalbonds
Sovereign bonds
Asset-Backed Securities and Non-Agency Mortgage-Backed Securities: Assetbacked
securities and non-agency mortgage-backed securities expose investors to credit risk. The
three nationally recognized statistical rating organizations rate asset-backed securities.
We begin with the factors considered by rating agencies in assigning ratings to assetbacked securities. Then we will discuss how the agencies differ with respect to rating
asset-backed securities versus corporate bonds.
C) Factors Considered by Rating Agencies In analyzing credit risk, the rating
companies focus on:
V. Creditquality of the collateral
VI.
Quality of the seller/servicer
VII.
Cash flow stress and payment structure, and
VIII.
Legal structure. We discuss each below:
Credit Quality of the Collateral: Analysis of the credit quality of the collateral depends on the
asset type. The rating companies will look at the underlying borrowers ability to pay and the
borrowers equity in the asset. The latter will be a key determinant as to whether the underlying
borrower will default or sell the asset and pay off a loan.
The concentration of loans is examined. The underlying principle of asset securitization is that
the large number of borrowers in a pool will reduce the credit risk via diversification. If there are
a few borrowers in the pool that are significant in size relative to the entire pool balance, this
diversification benefit can be lost, resulting in a higher level of default risk. This risk is called
concentration risk.
Quality of the Seller/Servicer: All loans must be serviced. Servicing involves collecting
payments from borrowers, notifying borrowers who may be delinquent, and, when necessary,
recovering and disposing of the collateral if the borrower does not make loan repayments by a
specified time. These responsibilities are fulfilled by a third-party to an asset-backed securities
transaction called a servicer. The servicer may be the originator of the loans used as the
collateral.
Cash Flow Stress and Payment Structure: As explained asset-backed securities; the waterfall
describes how the cash flow (i.e., interest and principal payments) from the collateral will be
distributed to pay trustee fees, servicing fees, other administrative fees, and interest and principal
to the bondholders in the structure. In determining a rating for bond class, the process begins

with an analysis of the cash flow from the collateral under different assumptions about losses and
delinquencies and economic scenarios established by the rating agency.
Legal Structure: A corporation using structured financing seeks a rating on the securities it
issues that is higher than its own corporate bond rating. If that is not possible, the corporation
seeking funds would be better off simply issuing a corporate bond.
D) Corporate Bond versus Asset-Backed SecuritiesCredit Analysis:Lets look at how the
rating of an asset-backed security differs from that of a corporate bond issue. To
understand the difference, it is important to appreciate how the cash flow that must be
generated differs for a corporate bond issue and a securitization transaction from which
the asset-backed securities are created.
4) Municipal Bonds Earlier we discussed municipal bonds available in the United States
tax-backed debt and revenue bonds. However, municipal governments in other countries
are making greater use of bonds with similar structures to raise funds. Below we discuss
the factors that should be considered in assessing the credit risk of an issue.
D) Tax-Backed Debt: In assessing the credit risk of tax-backed debt, there are four basic
categories that should be considered. The first category includes information on the
issuers debt structure to determine the overall debt burden. The second category
relates to theissuers ability and political discipline to maintain sound budgetary
policy. The third category involves determining the specific local taxes and
intergovernmental revenues available to the issuer, as well as obtaining historical
information both on tax collection rates, which are important when looking at
property tax levies, and on the dependence of local budgets on specific revenue
sources.
E) Revenue Bonds: Revenue bonds are issued for either project or enterprise financings
where the bond issuers pledge to the bondholders the revenues generated by the
operating projects financed, or for general public-purpose financings in which the
issuers pledge to the bondholders the tax and revenue resources that were previously
part of the general fund. While there are numerous security structures for revenue
bonds, the underlying principle in assessing an issuers credit worthiness is whether
the project being financed will generate sufficient cash flows to satisfy the obligations
due bondholders. Consequently, the analysis of revenue bonds is similar to the
analysis of corporate bonds.
The limits of the basic security,
The flow-of-funds structure,
The rate, or user-charge, covenant,
The priority-of-revenue claims,
The additional-bonds tests, and
Other relevant covenants.
vii.
Limits of the Basic Security: The trust indenture and legal opinion should explain
the nature of the revenues for the bonds and how they realistically may be limited by

federal, state, and local laws and procedures. The importance of this is that while
most revenue bonds are structured and appear to be supported by identifiable revenue
streams, those revenues sometimes can be negatively affected directly by other levels
of government.
viii. Flow of Funds Structure for Revenue Bonds: For a revenue bond, the revenue of
the enterprise is pledged to service the debt of the issue. The details of how revenue
received by the enterprise will be disbursed are set forth in the trust indenture.
Typically, the flow of funds for a revenue bond is as follows. First, all revenues from
the enterprise are put into a revenue fund. It is from the revenue fund that
disbursements for expenses are made to the following funds: operation and
maintenance fund, sinking fund, debt service reserve fund, renewal and replacement
fund, reserve maintenance fund, and surplus fund.
ix.
Rate, or User-Charge, Covenants: There are various restrictive covenants included
in the trust indenture for a revenue bond to protect the bondholders. A rate covenant
(or user charge covenant) dictates how charges will be set on the product or service
sold by the enterprise. The covenant could specify that the minimum charges be set so
as to satisfy both expenses and debt servicing, or to yield a higher rate to provide for a
certain amount of reserves.
x.
Priority-of-Revenue Claims: The legal opinion as summarized in the official
statement should clearly indicate whether or not others can legally tap the revenue of
the issuer even before they start passing through the issuers flow-of-funds structure
xi.
Additional-Bonds Test: An additional-bonds test covenant indicates whether
additional bonds with the same lien (i.e., claim against property) may be issued. If
additional bonds with the same lien may be issued, the conditions that must first be
satisfied are specified. Other covenants specify that the facility may not be sold, the
amount of insurance to be maintained, requirements for recordkeeping and for the
auditing of the enterprises financial statements by an independent accounting firm,
and requirements for maintaining the facilities in good order.
xii.
Other Relevant Covenants: There are other relevant covenants for the bondholders
protection that the trust indenture and legal opinion should cover. These usually
include pledges by the issuer of the bonds to have insurance on the project, to have
accounting records of the issuer annually audited by an outside certified public
accountant, to have outside engineers annually review the condition of the facility,
and to keep the facility operating for the life of the bonds.
F) Corporate versus Municipal Bond Credit Analysis: The credit analysis of
municipal bonds involves the same factors and quantitative measures as in corporate
credit analysis. For tax-backed debt, the analysis of the character of the public
officials is the same as that of the analysis of the character of management for a
corporate bond. The analysis of the ability to pay in the case of tax-backed debt
involves looking at the ability of the issuing entity to generate taxes and fees. As a
corporate analyst would look at the composition of the revenues and profits by

product line for a corporation, the municipal analyst will look at employment,
industry, and real estate valuation trends needed to generate taxes and fees. The credit
analysis of municipal revenue bonds is identical to that of a corporate bond analysis.
Effectively, the enterprise issuing a municipal revenue bond must generate cash flow
from operations to satisfy the bond payments. The covenants that are unique to a
municipal revenue bond and impact the credit analysis are the rate covenants and the
priority-of-revenue covenants. The former dictates how the user charges will be set to
meet the bond obligations.

Sovereign Bonds:
The debt of othernational governmentsis ratedby nationally recognized statistical rating
organizations. Standard & Poors and Moodys rate sovereign debt. The two general categories:
I.
II.

Economic risk
Political risk.

Economic risk
It represents S&Ps assessment of the ability of a government to satisfy its obligations. Both
quantitative and qualitative analyses are used in assessing economic risk.
Political risk
Political risk is an assessment of the willingness of a government to satisfy its obligations.
Political risk is assessed based on qualitative analysis of the economic and political factors that
influence a governments economic policies.
Types of Rating Assigned to National Government:
1. Local Currency Debt Rating:
A government can control its domestic financial system. It can generate sufficient local currency
to meet its local currency debt obligation. In assessing the credit quality of local currency debt,
the key factors looked at by S&P are:

The stability of political institutions and degree of popular participation in the political
process,
Income and economic structure,
Fiscal policy and budgetary flexibility,
Monetary policy and inflation pressures, and
Public debt burden and debt service track record.
2. Foreign Currency Debt Rating:
A government cannot control foreign exchange market. As a result defaults have been greater on
foreign currency denominated debt. Because a national government must purchase foreign
currency to meet a debt obligation. Thus, a significant depreciation of the local currency relative
to a foreign currency in which a debt obligation is denominated will impair a national

governments ability to satisfy a foreign currency obligation. For foreign currency debt, credit
analysis by S&P focuses on:

The interaction of domestic and foreign government policies

A countrys balance of payments and
The structure of its external balance sheet.
The net public debt, total net external debt, and net external liabilities.

CREDIT SCORING MODELS:

Edward Altman, the primary innovator of MDA (multiple discriminant analysis), a model is used
to assess default risk. One of the chief advantages of MDA is that it permits a simultaneous
consideration of a large number of characteristics and does not restrict the investigator to a
sequential evaluation of each individual attribute. MDA is applied to rate bonds and to predict
bankruptcy.
In one of Altmans earlier models, referred to as the Z-score model, he found that the
following MDA could be used to predict corporate bankruptcy
Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5
Where
X1 = Working capital/Total assets (in decimal), X2 = Retained earnings/Total assets (in
decimal), X3 = Earnings before interest and taxes/Total assets (in decimal), X4 = Market value
of equity/Total liabilities (in decimal), X5 = Sales/Total assets (number of times) Z = Z-score.
Altman found that Z-scores less than 1.81 indicated a firm with serious credit problems while a
Z-score in excess of 3.0 indicated a healthy firm.
Subsequently, Altman and his colleagues revised the Z-score model based on more recent data.
The resulting model Zeta model found that the following seven variables were important in
predicting corporate bankruptcies and were highly correlated with bond ratings

Earnings before interest and taxes (EBIT)/Total assets

Standard error of estimate of EBIT/Total assets (normalized) for 10 years
EBIT/Interest charges
Retained earnings/Total assets
Current assets/Current liabilities
Five-year average market value of equity/Total capitalization
Total tangible assets, normalized

Limitation of Credit Scoring Model:

It is not the replacement of human judgement.
It tends to classify as troubled credits not only most of the companies that eventually
default, but also many that do not default.

companies can default for reasons that a model based on reported financial data cannot
pick up by Friedson

CREDIT RISK MODELS:

Historically, credit risk modeling has focused on credit ratings, default rates, and traditional
credit analysis. In recent years, models for assessing credit risk to value corporate bonds have
been introduced. The models can be divided into two groups:
1. Structural Models:
Structural models are credit risk models developed on the basis of option pricing theory
presented by Fisher Black and Mryon Scholes and Robert Merton. In these models it has been
demonstrated that default can be modeled as an option to the stockholders granted by the
bondholders and, the use of the option pricing theory set forth by Black-Scholes-Merton (BSM)
provides a significant improvement over traditional methods for valuing default risky bonds.
2. Reduced Form Models:
The reduced form models do not look inside the firm, but instead model directly the
probability of default or downgrade. That is, the default process and the recovery process are (1)
modeled independently of the corporations structural features and (2) are independent of each
other. The two most popular reduced form models are:
I.
II.

Jarrow and Turnbull model

The Duffie and Singleton model