Credit Analysis and Other Important Considerations

Information on a corporate bond can be found in a document, known as an offering document, prospectus or official statement, which is usually provided to you by your investment advisor and helps an investor evaluate whether the bond issuer will be able to make its regularly scheduled interest payments for the term of the bond.

While no single source of information should be relied on exclusively, rating agencies, securities firms, and bank research staff monitor the various corporate,  government and other issuers’ financial condition and ability to make interest and principal payments when due. Your investment advisor, or sometimes the issuer of the bond, can supply you with current research.

Credit ratings.  In the United States, major rating agencies include Moody’s Investors Service, Standard & Poor’s Corporation and Fitch Ratings. Each agency assigns its ratings based on analysis of the issuer’s financial condition and management, economic and debt characteristics, and the specific revenue sources securing the bond. The highest ratings are AAA (S&P and Fitch Ratings) and Aaa (Moody’s).

Bonds rated in the BBB-/Baa3 category or higher are considered investment-grade; bonds with lower ratings are considered high yield, or speculative.

Lower ratings are indicative of a bond that has a greater risk of default than a bond with higher ratings. It is important to understand that the high interest rate that generally accompanies a bond with a lower credit rating is being provided in exchange for the investor taking on the risk associated with a higher likelihood of default.

The rating agencies make their ratings available to the public through their ratings information desks and online through their respective websites. In addition, their published reports and ratings are available in many local libraries.  Usually, rating agencies will signal they are considering a rating change by placing the bond on CreditWatch (S&P), Under Review (Moody’s) or on Rating Watch (Fitch Ratings).

Not all credit rating agency evaluations result in the same credit rating, so it is important to review all available credit ratings. It is also important to read the credit reports and related updates to properly evaluate the underlying credit risks. You should bear in mind that ratings are opinions, and you should understand the context and rationale for each opinion. Investors should not rely solely on credit ratings as a measure of credit risk, but instead use a multitude of resources to assist in their evaluation and decision making. Additional sources of information include recent independent news reports, formal issuer press releases, research reports and company financial statements.

Reviewing Your Investments

As described in this investor guide, there are many factors to be considered when evaluating a potential investment in corporate bonds.  To review some of the risks discussed:

  • Corporate bond prices fluctuate; the price might decline in the event of economic weakness or recession or if interest rates rise.
  • A corporate bond’s price may decline if the issuing company’s credit rating is lowered or because of unexpected news or financial results at the issuing company, or within the company’s industry.
  • A bond may default if the issuer does not pay the interest or principal as required.
  • An investor may have difficulty locating a buyer at certain times, as some bond investments may be less liquid than other types of investments.

Corporate bond investors require a tolerance for risk, along with the ability to weather periodic market downturns or unexpected events that negatively impact individual issues.

A review of corporate debt investments with your financial advisor should cover a variety of factors, including:

  • analysis of the industry, including growth rates, special risks and leading companies;
  • analysis of the bond issuer, including the company’s position in its industry; new products; management stability; the outlook for growth in revenues and cash flow as captured in Earnings Before Interest, Taxes, Depreciation and Amortization, also called EBITDA; value of corporate assets and the debt maturity schedule; and
  • analysis of the issue, including special provisions in the “bond indenture,” covenants protecting the bondholder, use of the money raised in bond offerings, debt seniority, secondary market liquidity and call provisions.

In addition to the above, bond investors should consider addressing risk factors in this market by:

  • diversifying across issuers and industry segments;
  • adjusting portfolios over economic and market cycles;
  • monitoring rating agencies and other credit research; and
  • monitoring company and industry news.

Considerations of suitability and alignment with your investment objectives should always be taken into account before making any investment. Contact your financial advisor to discuss possible investments.

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