High-Yield Credit Analysis: A Closer Look | CFA Level I Fixed Income
Investment-grade corporate bonds have been the focus of our discussions so far. However, there are some unique aspects to consider when analyzing high-yield corporate bonds, also known as junk bonds. These bonds carry a higher perceived credit risk and are rated below BBB- by credit rating agencies. In this lesson, we’ll delve into the special considerations for evaluating the creditworthiness of high-yield bonds and how they differ from investment-grade bonds.
Why Some Bonds Get a Low Rating
Several factors can contribute to a bond receiving a low rating:
- Highly leveraged capital structure
- Weak or limited operating history
- Low or negative free cash flow
- Highly cyclical business
- Low confidence in management
- Unclear competitive advantages
- Large off-balance-sheet liabilities
- And a declining industry
Special Considerations in High-Yield Credit Analysis
Since high-yield bonds have a higher default risk than investment-grade bonds, the analysis must be more in-depth, focusing on:
- Liquidity and cash flow
- Detailed financial projections
- Understanding and analysis of the debt structure
- Understanding of the issuer’s corporate structure
- And covenants
1. Liquidity and Cash Flow
Liquidity is crucial for high-yield issuers as they often have limited access to additional borrowings, and available funds can be more expensive. Issuer liquidity is a key focus in high-yield analysis, and sources of liquidity include:
- Cash on the balance sheet
- Working capital
- Operating cash flow
- Bank lines or credit facilities
- Equity issuance (unreliable source for privately-owned issuers)
- Asset sales (least reliable source)
2. Financial Projections
It’s essential to forecast future earnings and cash flow for high-yield companies to assess the issuer’s risk of default. The analyst should also project changes in capital expenditures and working capital, paying special attention to realistic “stress” scenarios that could expose a borrower’s vulnerabilities.
3. Debt Structure Analysis
High-yield issuers often have various debt types with different seniority levels, affecting potential loss severity. A credit analyst should calculate leverage ratios for each debt level to determine the debt structure’s top-heaviness.
4. Corporate Structure
Many high-yield companies use a holding company structure, with a parent company receiving dividends from subsidiaries as its primary source of operating income. This can create a scenario called structural subordination, where bonds issued by the parent are effectively subordinated to the bonds issued by the subsidiary. Despite structural subordination, a parent company’s credit rating may be superior to subsidiaries’ ratings because the parent can benefit from having access to multiple cash flows from diverse subsidiaries.
Covenants are particularly important for high-yield bonds due to their reduced margin of safety. Key covenants to examine include:
- Change of control put covenants
- Restricted payments covenant
- Limitations on liens covenant
- Classification of subsidiaries as restricted or unrestricted
Bank covenants, typically more restrictive than bond covenants, can also be imposed on high-yield issuers. Violating these covenants can trigger a default by accelerating the full repayment of a loan.
High-Yield Bonds: A Hybrid of Investment-Grade Bonds and Equity
High-yield bonds can be viewed as a hybrid of investment-grade bonds and equity. Their price and spread movements are influenced by interest rate changes, albeit to a lesser extent than investment-grade bonds, and show greater correlation with movements in equity markets.
High-yield bond analysis can incorporate some equity market analysis techniques, such as enterprise value (EV), a measure of a business’s worth before any takeover premium. Comparing firms based on the differences between their EV-to-EBITDA and debt-to-EBITDA ratios can provide insights into their credit risk.
In conclusion, high-yield credit analysis requires a more in-depth approach than investment-grade analysis. Understanding the issuer’s liquidity, financial projections, debt structure, corporate structure, and covenants is crucial for evaluating the creditworthiness of high-yield bonds.