The goal of credit analysis is to access the probability that the bonds or loans in question will be repaid at maturity. When making a decision to buy a bond, the analyst must decide if the bonds are trading at a high enough yield to compensate for the risk of holding the bond. But the primary goal is to select credits that have a high degree of confidence of being repaid at maturity because if a company defaults, there usually isn’t a yield high enough to compensate for the loss.
These are the steps to take for credit analysis.
Industry analysis
Many industries have disappeared over the years such as the horse carriage and buggy whip industries and more recently telephone directories and typewriter makers. Other industries have shrunk in size and have struggled to maintain profitability including newspaper publishing and video rentals. A credit analyst must be aware of the industry structure and trends and be able to make an assessment about the future of the industry. See Industry Analysis.
Company analysis
It is imperative to understand what the company sells and how it generates cash. The best way to obtain this information is by reading the company’s 10K and annual report. These documents can be found on the SEC website and are good sources of information. Once you understand the company’s business, determine how the company fits within the industry compared to competitors and whether the company has a competitive advantage. See Company Analysis.
Financial analysis
A good credit analysis should be forward looking since the ability of a company to repay its bonds will depend on future performance. However, analyzing historical financials will provide a good idea of how the company performs over different economic cycles and industry changes. It would be helpful to obtain the compnay’s last 10 years (or at least 5) of financial statements and observe how different financial metrics have changed over time. Next, based on your views of the industry, company and historical financials, forecast longer term performance for the company and determine the risk of the company’s ability to repay the bonds. See Financial Analysis.
Structure and maturity schedule analysis
A company usually has many different credit obligations within its capital structure. Determine where the bond in question fits within the capital structure. How much debt is senior to the bond? How much debt is scheduled to mature before the bond? Are these bonds structurally subordinated? See Structure and Maturity Schedule.
Indenture analysis
Credit analysts should be familiar with not only the indenture of the bond being analyzed but also the indentures or credit agreements of the company’s other debts. Understanding this information will help you understand how well protected the bond is from management and corporate actions. See Indenture Analysis.
Putting it all together
Based on your credit analysis, try to assign a credit rating for the debt. This rating may or may not agree with the ratings of S&P or Moody’s but it will give you a good assessment of the credit risk. Particularly with convertible bonds, there may not be an agency rating issued. Once you determine the overall rating, you can measure it against other companies with the same rating and determine whether the security is cheap or rich by looking at the following chart.
This chart only serves as a guideline. For example, while the average BB credit spread is 532, there are many BB credits that trade above or below that spread for good reasons. Review your credit analysis and determine how much above or below the credit should trade compared to the rating category.