Credit Risk Analysis
How Financial Markets Price Corporate Debt
Companies seeking to borrow large amounts in the “below investment grade debt markets” begin the process by contacting an investment bank which syndicates below investment grade debt.
Once the type of debt (leveraged loan, high yield bond, etc.) has been determined the investment bank uses its knowledge of market conditions to structure the transaction and to estimate pricing for the new debt issue. During this phase of the syndication process, the investment bank might consult a Fair Market Sector Curve to assess market conditions. Investor sentiment can change rapidly and the investment bank’s knowledge of investor receptiveness to specific transactions quickly becomes obsolete. If the investment bank’s knowledge of market conditions has become stale, it will informally contact large potential investors in the subject instrument prior to syndication for guidance regarding how the instrument should be structured and priced.
The investment bank will use this knowledge to prepare syndication documents and to formally present the investment opportunity to investors in syndication. During the syndication process, investors perform their own due diligence on the prospective borrower and the debt instrument. If the investment is well received by investors, demand from investors will exceed the supply of debt offered by the borrower. When this happens, the interest rate on the debt instrument is reduced from the original guidance presented to investors. If the investment is poorly received by investors, the interest rate on the debt instrument may be raised from initial guidance to entice investor commitments.
Large debt instruments are not priced on Fair Market Sector Curves in large transactions. Corporate treasurers will seek to borrow at rates below the Fair Market Sector Curve if they believe their debt instrument is favorable relative to the curve. Likewise, if investors consider the risk presented by the subject debt instrument to be above average, they will demand interest rates exceeding the curve rate.
The 5 C’s of Credit
The five C’s of credit include: Character, Capacity, Collateral, Capital and Conditions. The Moody’s credit rating factors place heavy emphasis on the issues of Character and Capacity but give almost no consideration to the issues of how investors value the business (Capital) or cash flow and asset value volatility (Conditions). These factors are critical elements of any thorough credit analysis.
Character: Sometimes called credit history, refers to a borrower’s reputation or track record for repaying debts.
Capacity: Capacity measures a borrower’s ability to repay a loan by comparing income against recurring debts and assessing the borrower’s debt-to-income (DTI) ratio.
Capital: Lenders also consider any capital the borrower puts toward a potential investment. A large contribution by the borrower decreases the chance of default.
Collateral: Collateral can help a borrower secure loan. It gives the lender the assurance that if the borrower defaults on the loan, the lender can repossess the collateral.
Conditions: The conditions of the loan, such as its interest rate and amount of principal, influence the lender’s desire to finance the borrower. Conditions refer to how a borrower intends to use the money.
Alternative Indications of Credit Quality
Professional investors in the leveraged credit markets consider the opinions of the major credit rating agencies but they also make their own assessments regarding the credit quality of the debt instruments in which they invest. As a result, it is common for some B1 rated instruments to be priced in a manner that is more consistent with Ba3 rated debt while others trade more like B2 rated debt.
Leveraged debt investors consider all of the 5 C’s of credit factors but they also consider other highly relevant factors such as the value of the debt issuer’s assets and the expected volatility of its future earnings. These factors are very important to investors, but they are not contemplated in the Moody’s Methodology.
Thus, while consideration of the Moody’s rating is completely relevant when pricing the debt, additional analyses also merit consideration. To gain additional perspective about how investors would have considered the debt, one should apply the KMV-Merton model and a cash flow volatility analysis using a cash flow simulation.
KMV Merton Model Analysis
The probability of default for a debt instrument affects the credit rating assigned as well as the terms and the interest rate required by investors. All else equal, the higher the probability of default, the higher the interest rate required by investors and the lower the credit rating assigned.
The relationship between the actual occurrence of default (i.e., the default rate) and credit rating is captured in Moody’s Default and Recovery Rates of Corporate Bond Issuers reports.
Probability of Default Models
- Classification. Classification models are used to test credit and gauge the likelihood of bankruptcy of companies. They typically utilize an analysis of ratios including profitability, leverage, liquidity, solvency, and activity to estimate the probability of a company being insolvent. Some examples of classification models include the Altman Z-Score model and Zeta credit-risk model.
- Structural. In a structural default forecasting model, a company is assumed to go bankrupt when the value of the firm is less than the value of the debt. At this firm value, the equity value is zero, and the equity owners will put the assets of the insolvent firm to the debt holders by defaulting. This would be the case under arm’s length transactions.
- Hazard. The hazard model is used to forecast bankruptcy through various market driven variables over a period of time rather than traditional single-period classification models that use accounting ratios. By forecasting over a period of time, the model uses more data than traditional models. The hazard model incorporates time-varying covariates, and it adjusts for period at risk. These advantages of the hazard model result in precise estimates and superior forecasts.
The KMV-Merton model is used to estimate the total value of loans that would have been made by an arms-length, third party lender, is a structural model based on Merton’s 1974 bond pricing model and the KMV model. Below, we discuss the Merton bond pricing model, the KMV model and the KMV-Merton model.
The Merton Bond Pricing Model
Merton’s 1974 bond pricing model, based on the Black-Scholes option pricing model (OPM), calculates the price of a risky bond as the price of a risk-free bond less the price of a put option on the value of the assets of the firm. The Merton bond pricing model makes two important assumptions:
The total value of a firm follows a geometric Brownian motion
The firm has one zero-coupon discount bond that matures in T periods
In the Merton framework, the value of a firm’s risk bond (B*) is calculated as:
where:
The KMV Model
The KMV model is a commercial default-forecasting model developed by the KMV Corporation in the late 1980’s based on Merton’s 1974 bond pricing model. The KMV model has been used by Wall Street, money center banks since the 1980’s to assess default risk. In 2002, the KMV Corporation was acquired by Moody’s. The KMV model is still widely used today. According to Moody’s, it is used at more than 2,000 firms globally. The US Comptroller of the Currency also identifies the KMV style analysis as an acceptable tool for bank use in evaluation of credit risk. The Basel Committee on Banking Supervision has also endorsed the KMV analysis.
The process used by the KMV model to estimate the Expected Default Frequency (EDF). Estimate the EDF using the computed distance to default and a proprietary default database. The expected default frequency is determined by looking at the firms in the database with the same distance to default and determining the percentage of firms that default.
Credit Metric Comparison
To assess the credit worthiness relative to the closest comparable companies, one needs to look at a number of leverage and solvency ratios, such as interest coverage and net debt to EBITDA.
- EBITDA / Interest
- Net Debt / EBITDA
- Net Debt / (EBITDA – Capital Expenditures)
- Net Debt / Market Cap
