1. INTRODUCTION

The income statement presents information on the financial results of a company’s business activities over a period of time. The income statement communicates how much revenue the company generated during a period and what costs it incurred in connection with generating that revenue. The basic equation underlying the income statement, ignoring gains and losses, is Revenue minus Expenses equals Net income. The income statement is also sometimes referred to as the “statement of operations,” “statement of earnings,” or “profit and loss (P&L) statement.” Under International Financial Reporting Standards (IFRS), the income statement may be presented as a separate statement followed by a statement of comprehensive income that begins with the profit or loss from the income statement or as a section of a single statement of comprehensive income.1 US generally accepted accounting principles (US GAAP) permit the same alternative presentation formats.2 This reading focuses on the income statement, but also discusses comprehensive income (profit or loss from the income statement plus other comprehensive income).

Investment analysts intensely scrutinize companies’ income statements.3 Equity analysts are interested in them because equity markets often reward relatively high- or low-earnings growth companies with above-average or below-average valuations, respectively, and because inputs into valuation models often include estimates of earnings. Fixed-income analysts examine the components of income statements, past and projected, for information on companies’ abilities to make promised payments on their debt over the course of the business cycle. Corporate financial announcements frequently emphasize information reported in income statements, particularly earnings, more than information reported in the other financial statements.

Under International Financial Reporting Standards (IFRS), the income statement may be presented as a separate statement followed by a statement of comprehensive income that begins with the profit or loss from the income statement or as a section of a single statement of comprehensive income.1 US generally accepted accounting principles (US GAAP) permit the same alternative presentation formats.2

Investment analysts intensely scrutinize companies’ income statements.3 Equity analysts are interested in them because equity markets often reward relatively high- or low-earnings growth companies with above-average or below-average valuations, respectively, and because inputs into valuation models often include estimates of earnings. Fixed-income analysts examine the components of income statements, past and projected, for information on companies’ abilities to make promised payments on their debt over the course of the business cycle. Corporate financial announcements frequently emphasize information reported in income statements, particularly earnings, more than information reported in the other financial statements.

LEARNING OUTCOMES

The candidate should be able to:

1. describe credit risk and credit-related risks affecting corporate bonds;

2. describe default probability and loss severity as components of credit risk;

3. describe seniority rankings of corporate debt and explain the potential violation of the priority of claims in a bankruptcy proceeding;

4. distinguish between corporate issuer credit ratings and issue credit ratings and describe the rating agency practice of “notching”;

5. explain risks in relying on ratings from credit rating agencies;

6. explain the four Cs (Capacity, Collateral, Covenants, and Character) of traditional credit analysis;

7. calculate and interpret financial ratios used in credit analysis;

8. evaluate the credit quality of a corporate bond issuer and a bond of that issuer, given key financial ratios of the issuer and the industry;

9. describe factors that influence the level and volatility of yield spreads;

10. explain special considerations when evaluating the credit of high yield, sovereign, and non-sovereign government debt issuers and issues.

Default risk

The probability that a borrower defaults or fails to meet its obligation to make full and timely payments of principal and interest, according to the terms of the debt security. Also called default probability.

The loss severity, and hence the expected loss, can be expressed as either a monetary amount (e.g., €450,000) or as a percentage of the principal amount (e.g., 45 percent). The latter form of expression is generally more useful for analysis because it is independent of the amount of investment. Loss severity is often expressed as (1 – Recovery rate), where the recovery rate is the percentage of the principal amount recovered in the event of default.

• Spread risk. Corporate bonds and other “credit-risky” debt instruments typically trade at a yield premium, or spread, to bonds that have been considered “default-risk free,” such as US Treasury bonds or German government bonds. Yield spreads, expressed in basis points, widen based on two primary factors: (1) a decline in an issuer’s creditworthiness, sometimes referred to as credit migration or downgrade risk, and (2) an increase in market liquidity risk. These two risks are separate but frequently related.

Credit migration risk or downgrade risk. This is the risk that a bond issuer’s creditworthiness deteriorates, or migrates lower, leading investors to believe the risk of default is higher and thus causing the yield spreads on the issuer’s bonds to widen and the price of its bonds to fall. The term “downgrade” refers to action by the major bond rating agencies

Market liquidity risk. This is the risk that the price at which investors can actually transact—buying or selling—may differ from the price indicated in the market. To compensate investors for the risk that there may not be sufficient market liquidity for them to buy or sell bonds in the quantity they desire, the spread or yield premium on corporate bonds includes a market liquidity component, in addition to a credit risk component. Unlike stocks, which trade on exchanges, most markets bonds trade primarily over the counter, through broker–dealers trading for their own accounts. Their ability and willingness to make markets, as reflected in the bid–ask spread, is an important determinant of market liquidity risk. The two main issuer-specific factors that affect market liquidity risk are (1) the size of the issuer (that is, the amount of publicly traded debt an issuer has outstanding) and (2) the credit quality of the issuer. In general, the less debt an issuer has outstanding, the less frequently its debt trades, and thus the higher the market liquidity risk. And the lower the quality of the issuer, the higher the market liquidity risk

3.1. Capital Structure

The composition and distribution across operating units of a company’s debt and equity—including bank debt, bonds of all seniority rankings, preferred stock, and common equity—is referred to as its capital structure. Some companies and industries have straightforward capital structures, with all the debt equally ranked and issued by one main operating entity. Other companies and industries, due to their frequent acquisitions and divestitures (e.g., media companies or conglomerates) or high levels of regulation (e.g., banks and utilities), tend to have more complicated capital structures. Companies in these industries often have many different subsidiaries, or operating companies, that have their own debt outstanding and parent holding companies that also issue debt, with different levels or rankings of seniority. Similarly, the cross-border operations of multi-national corporations tend to increase the complexity of their capital structures.

3.2. Seniority Ranking

Just as borrowers can issue debt with many different maturity dates and coupons, they can also have many different rankings in terms of seniority. The ranking refers to the priority of payment, with the most senior or highest-ranking debt having the first claim on the cash flows and assets of the issuer. This level of seniority can affect the value of an investor’s claim in the event of default and restructuring. Broadly, there is secured debt and unsecured debt. Unsecured bonds are often referred to as debentures. Secured debt means the debtholder has a direct claim—a pledge from the issuer—on certain assets and their associated cash flows. Unsecured bondholders have only a general claim on an issuer’s assets and cash flow. In the event of default, unsecured debtholders’ claims rank below (i.e., get paid after) those of secured creditors3 under what’s known as the priority of claims.

Within each category of debt, there are finer gradations of types and rankings. Within secured debt, there is first mortgage and first lien debt, which are the highest-ranked debt in terms of priority of repayment. First mortgage debt or loan refers to the pledge of a specific property (e.g., a power plant for a utility or a specific casino for a gaming company). First lien debt or loan refers to a pledge of certain assets that could include buildings but might also include property and equipment, licenses, patents, brands, and so on. There can also be second lien, or even third lien, secured debt, which, as the name implies, has a secured interest in the pledged assets but ranks below first lien debt in both collateral protection and priority of payment.

Within each category of debt, there are finer gradations of types and rankings. Within secured debt, there is first mortgage and first lien debt, which are the highest-ranked debt in terms of priority of repayment. First mortgage debt or loan refers to the pledge of a specific property (e.g., a power plant for a utility or a specific casino for a gaming company). First lien debt or loan refers to a pledge of certain assets that could include buildings but might also include property and equipment, licenses, patents, brands, and so on. There can also be second lien , or even third lien, secured debt, which, as the name implies, has a secured interest in the pledged assets but ranks below first lien debt in both collateral protection and priority of payment.

Within unsecured debt, there can also be finer gradations and seniority rankings. The highest-ranked unsecured debt is senior unsecured debt. It is the most common type of all corporate bonds outstanding. Other, lower-ranked debt includes subordinated debt and junior subordinated debt. Among the various creditor classes, these obligations have among the lowest priority of claims and frequently have little or no recovery in the event of default. That is, their loss severity can be as high as 100 percent. (See Exhibit 1 for a sample seniority ranking.) For regulatory and capital purposes, banks in Europe and the United States have issued debt and debt-like securities that rank even lower than subordinated debt4 and are intended to provide a capital cushion in times of financial distress. Many of them did not work as intended during the financial crisis that began in 2008, and most were phased out, potentially to be replaced by more effective instruments that automatically convert to equity in certain circumstances.

There are many reasons why companies issue—and investors buy—debt with different seniority rankings. Issuers are interested in optimizing their cost of capital—finding the right mix of the various types of both debt and equity—for their industry and type of business. Issuers may offer secured debt because that is what the market (i.e., investors) may require, given a company’s perceived riskiness, or because secured debt is generally lower cost due to the reduced credit risk inherent in its higher priority of claims. Or, issuers may offer subordinated debt because (1) they believe it is less expensive than issuing equity5 (and doesn’t dilute existing shareholders) and is typically less restrictive than issuing senior debt and (2) investors are willing to buy it because they believe the yield being offered is adequate compensation for the risk they perceive. Credit risk versus return will be discussed in more detail later in the reading.