Issuance trading and funding - Credit analysis and ratings

Learning Outcomes

This article explains how credit analysis and credit ratings are used to evaluate an issuer’s ability to meet its debt obligations and how this knowledge is tested in the CFA Level 1 exam. It clarifies the main objectives of credit analysis, the distinctions among default, downgrade, and spread risk, and the qualitative and quantitative techniques analysts use to assess business, financial, and structural risk. It describes the key ratios—such as interest coverage, debt levels, and profitability—used to gauge indebtedness, cash flow adequacy, and overall creditworthiness, and shows how trends in these metrics feed into rating opinions. The article details the rating-agency process from information gathering to committee decision, explains the meaning of investment-grade versus speculative-grade ratings, and analyzes how rating levels and changes affect funding cost, market access, covenants, and secondary-market pricing. It also discusses issuer-specific risk drivers, including industry characteristics, management quality, and event risk, and highlights the role of forward-looking judgment and limitations of purely mechanical ratio-based assessment in real-world credit analysis.

CFA Level 1 Syllabus

For the CFA Level 1 exam, you are required to understand the fundamental principles of credit analysis and credit ratings, with a focus on the following syllabus points:

• Explain the purpose and typical users of credit analysis and ratings.
• Identify and interpret key factors affecting a company’s creditworthiness.
• Describe the process and key criteria used by rating agencies to assign corporate credit ratings.
• Understand the implications of credit ratings for issuer funding, trading, and risk management.
• Distinguish among types of credit risk, including default risk, downgrade risk, and spread risk.
• Interpret basic credit ratios related to profitability, indebtedness, coverage, and cash flow.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following best describes downgrade risk for a bond investor?
   1. The risk that the issuer fails to make a scheduled payment of interest or principal.
   2. The risk that the issuer’s credit rating is lowered, increasing its borrowing cost.
   3. The risk that market interest rates fall, reducing reinvestment income.
   4. The risk that bond prices rise because of a narrowing yield spread.
2. A company has EBITDA of 300, interest expense of 60, and total debt of 900. Which statement is most accurate?
   1. Interest coverage of 5.0 and Debt/EBITDA of 2.0 indicate relatively low credit risk.
   2. Interest coverage of 5.0 and Debt/EBITDA of 3.0 indicate relatively low credit risk.
   3. Interest coverage of 4.0 and Debt/EBITDA of 2.0 indicate relatively high credit risk.
   4. Interest coverage of 4.0 and Debt/EBITDA of 3.0 indicate relatively high credit risk.
3. An issuer is downgraded from BBB– to BB+. Which funding consequence is most likely?
   1. Lower coupon rates on new bonds and easier covenant terms.
   2. Little impact on new bond yields because both ratings are close.
   3. Higher coupon rates on new bonds and a reduced pool of eligible investors.
   4. Immediate default on all outstanding debt obligations.
4. Which statement about credit ratings is most accurate?
   1. Ratings are precise estimates of default probability over one year.
   2. Ratings are ordinal opinions of credit quality and may lag changes in market prices.
   3. Ratings directly determine bond prices, which change only when ratings change.
   4. Ratings apply only to issuers, not to individual bond issues.

Introduction

Credit analysis is the assessment of a borrower’s ability and willingness to meet its financial obligations in full and on time. It underpins decisions by bond investors, banks, and other lenders about whether to extend credit, under what terms, and at what required yield. It also informs internal risk management, regulatory capital assessments, and pricing of credit derivatives.

Key Term: credit risk
Credit risk is the risk that a borrower fails to make required payments of interest or principal on time or at all, or that its perceived credit quality deteriorates, causing losses to creditors.

Key Term: credit rating
A credit rating is an independent, standardized opinion issued by a rating agency assessing an issuer’s ability and willingness to fulfill its financial obligations, considering both the probability of default and likely recovery if default occurs.

Credit risk is not only about outright default. Market participants are also concerned with changes in credit quality and the compensation (yield spread) required for bearing that risk.

Key Term: credit spread
A credit spread is the difference between the yield on a risky bond and the yield on a default‑risk‑free benchmark bond of similar maturity, typically a government bond or an interest rate swap.

For exam purposes, it is helpful to think of credit risk in terms of expected loss:

Key Term: probability of default (PD)
Probability of default is the likelihood that an issuer will fail to make promised payments over a specified time horizon.

Key Term: loss given default (LGD)
Loss given default is the proportion of exposure that is not recovered if default occurs, equal to 1 minus the recovery rate.

Key Term: expected loss
Expected loss equals exposure at default × probability of default × loss given default. For a bond investor, exposure at default is usually close to par value.

Credit analysis aims to estimate these components qualitatively and quantitatively and to compare the risk–return trade-off across bonds and issuers.

FUNDAMENTALS OF CREDIT ANALYSIS

Credit analysis focuses on the likelihood that a borrower will fully and punctually repay its debt and on the potential loss if it does not. Analysts seek to answer: How risky is a loan or bond, and what price (interest rate and spread) compensates for that risk?

Types of Credit Risk

The main types of credit risk relevant for CFA Level 1 are:

Key Term: default risk
Default risk is the risk that the borrower fails to pay interest or principal as agreed, leading to a credit event and potential loss of principal.

Key Term: downgrade risk
Downgrade risk is the risk that a credit rating agency lowers the issuer’s or issue’s credit rating, reflecting a deterioration in perceived credit quality.

Key Term: spread risk
Spread risk is the risk that the market-required yield spread on the issuer’s debt widens, causing the bond’s price to fall, even if no default or rating change occurs.

These risks are closely related but distinct:

• Default risk is about non‑payment.
• Downgrade risk is about a formal reassessment of credit quality.
• Spread risk reflects changes in market sentiment or risk appetite that affect bond yields and prices.

For example, in a recession, investors may demand higher spreads on all corporate bonds. Even if a particular company remains profitable and its rating is unchanged, its bond price can fall because of spread risk.

The Credit Analysis Process

A typical credit analysis combines qualitative and quantitative assessment in three core areas:

Key Term: business risk
Business risk is the risk related to the company’s industry, competitive position, and operating environment that can affect the stability and level of its cash flows.

Key Term: financial risk
Financial risk is the risk arising from the company’s capital structure, debt levels, and financial policies that affects its ability to service debt.

Key Term: structural risk
Structural risk is the risk related to the legal and capital structure of the issuer, including the ranking and security of different debt instruments and the possibility of subordination.

The three main components are:

• Business risk:
  Analysts examine how stable and predictable revenues and margins are and how resilient the business model is. Key considerations include:

  • Industry cyclicality (for example, construction versus utilities).
  • Competitive intensity and barriers to entry.
  • Product and customer diversification.
  • Geographic diversification and exposure to emerging markets.
  • Regulatory environment and technological disruption.

• Financial risk:
  This focuses on:

  • Capital structure (mix of debt and equity).
  • Level of indebtedness relative to earnings and cash flow.
  • Stability and predictability of operating cash flows.
  • Liquidity (cash, marketable securities, committed credit lines).
  • Financial policy (tolerance for debt, dividend policy, share buybacks).

  Analysts adjust for off‑balance-sheet obligations, such as operating leases or guarantees, to capture the true economic indebtedness.

• Structural/management risk:
  This dimension covers:

  • Corporate structure (holding company versus operating company debt).
  • Seniority of different instruments and whether debt is secured or unsecured.
  • Presence and strength of covenants.
  • Quality and track record of management and corporate governance.
  • Ownership structure (for example, private equity ownership may imply higher appetite for debt).

Key Term: covenant
A covenant is a contractual clause in a debt agreement that restricts the borrower’s actions (negative covenant) or requires certain actions or minimum financial ratios (affirmative or maintenance covenant) to protect creditors.

To assess these areas, credit analysts use ratio analysis, business trend analysis, peer comparison, and scenario testing. They examine historical performance and forward‑looking projections under different economic scenarios.

Key Term: indebtedness
Indebtedness is the amount of debt used to finance a company’s assets, which increases both potential returns to equity holders and the risk borne by creditors.

Common Credit Ratios

Credit ratios translate financial statements into metrics that summarise profitability, indebtedness, coverage, and cash flow generation. At Level 1 you should be able to classify and interpret the key types.

Key Term: coverage ratio
A coverage ratio compares cash flows or operating profits with required fixed charges, chiefly interest payments; a higher ratio signals greater safety for creditors.

Some commonly used ratios include:

• Profitability and cash flow metrics:
  • EBITDA (Earnings before interest, taxes, depreciation, and amortization).
  • EBITDA margin = EBITDA / Revenue.
  • Free cash flow (FCF) = Cash flow from operations – Capital expenditure.
  • FCF after dividends to equity = FCF – Dividends paid.

Key Term: EBITDA
EBITDA is a measure of operating performance before non‑cash charges and financing and tax costs, often used as a proxy for cash flow available to service debt.

• Debt metrics:

  • Debt/EBITDA = Total debt ÷ EBITDA.
  • Debt/Capital = Total debt ÷ (Total debt + Equity).
  • Funds from operations (FFO)/Debt, where FFO adjusts net income for non‑cash items.

• Coverage metrics:

  • EBIT/Interest expense.
  • EBITDA/Interest expense.

• Liquidity metrics:

  • Current ratio = Current assets ÷ Current liabilities.
  • Cash and equivalents compared with upcoming debt maturities.

From the curriculum standpoint, note the classification:

• Profitability and cash flow: EBITDA, FCF.
• Debt ratios: Debt/EBITDA, Debt/Capital, FFO/Debt.
• Coverage: EBITDA/Interest, EBIT/Interest.

Higher profitability and cash flow, lower indebtedness, and higher coverage generally imply lower credit risk. However, interpretation must consider industry norms and company-specific characteristics.

Worked Example 1.1

A company reports (all amounts in millions): Net income 180; Depreciation and amortization 30; Deferred taxes 18; Other non‑cash items 28; Increase in working capital 52; Total debt 1,280. An analyst wants to calculate FFO/Debt as a debt metric. What is FFO/Debt and how would you interpret it?

Answer:
FFO (funds from operations) is calculated by adding back non‑cash items to net income, ignoring working capital changes:
FFO = 180 + 30 + 18 + 28 = 256.
FFO/Debt = 256 ÷ 1,280 = 0.20, or 20%.
An FFO/Debt of 20% means that, if FFO remained constant, the company would generate cash equal to 20% of its debt annually before capital expenditures and dividends. All else equal, a higher FFO/Debt ratio indicates lower credit risk.

CREDIT RATINGS: PROCESS AND IMPLICATIONS

Credit ratings are a key bridge between detailed credit analysis and market pricing.

The Rating Process

Credit ratings are typically issued by major agencies (such as S&P, Moody’s, and Fitch). They publish rating scales for both long‑term and short‑term instruments and perform ongoing surveillance.

The process generally involves:

• Information gathering:
  Analysts review audited financial statements, management discussion and analysis, business plans, debt documentation, and relevant industry data. They usually meet management to discuss strategy, risk management, and financial policy.

• Analysis:
  Agencies apply proprietary frameworks that combine:

  • Quantitative analysis (financial ratios, trend analysis, scenario analysis).
  • Qualitative assessment (business risk profile, competitive position, governance, country risk).

• Committee decision:
  Ratings are determined by a rating committee, not by a single analyst, to reduce individual bias and ensure consistency across issuers and sectors.

Key Term: issuer rating
An issuer rating is a rating agency’s opinion of an obligor’s overall capacity to meet its financial obligations on time, considering all senior unsecured debt.

Key Term: issue rating
An issue rating is the rating assigned to a specific debt instrument, reflecting both the issuer’s credit quality and the security and seniority of that instrument.

Ratings often differ between the issuer and individual issues because of structural features:

• Secured bonds can be rated above the issuer rating if collateral significantly improves expected recovery.
• Subordinated bonds can be rated below the issuer rating because they rank lower in the priority of claims.

Rating Scales and Investment Grade

Most agencies use letter-grade scales. The details differ slightly, but the broad structure is consistent.

Key Term: investment grade
Investment grade refers to ratings of BBB–/Baa3 or higher, indicating relatively low credit risk and strong capacity to meet financial commitments under normal conditions.

Key Term: speculative grade
Speculative grade (also called high yield or non‑investment grade) refers to ratings below BBB–/Baa3, indicating higher credit risk and greater sensitivity to adverse business, financial, or economic conditions.

At the top of the scale are AAA/Aaa ratings, indicating extremely strong credit quality. At the bottom are ratings such as C or D, indicating that default is highly likely or has already occurred.

Key Term: downgrade
A downgrade is a reduction in an issuer’s or issue’s credit rating, reflecting a materially increased risk of default or a deteriorating financial or business position.

Key Term: fallen angel
A fallen angel is a bond originally issued with an investment‑grade rating that has subsequently been downgraded to speculative grade.

Agencies also publish:

• Rating outlooks (positive, stable, negative), indicating the likely direction of ratings over a medium-term horizon.
• Rating watches or reviews, signalling that a rating is under active consideration for near‑term upgrade or downgrade.

Key Term: rating outlook
A rating outlook expresses the likely direction of a credit rating over the intermediate term (usually 6–24 months), such as positive, stable, or negative.

Interpreting Credit Ratings

Key points for interpretation at Level 1:

• Ratings are ordinal, not cardinal. An A rating is better than BBB, but ratings do not specify exact default probabilities. Agencies publish historical default statistics by rating category, but those are not fixed promises.
• Ratings are forward‑looking opinions, not guarantees. They incorporate expected recovery in default, not just probability of default.
• Ratings tend to be sticky and may lag market pricing:
  • Bond prices and spreads adjust continuously as new information arrives.
  • Rating changes are less frequent and may be announced after markets have already priced in deteriorating (or improving) credit fundamentals.

Because of these features, sophisticated investors treat ratings as a starting point and perform their own credit analysis. Over‑reliance on ratings can be dangerous, especially in complex securities or during periods of rapid change.

ISSUANCE, FUNDING, AND MARKET IMPLICATIONS

A company’s credit profile and rating significantly affect its ability to raise funds in the capital markets and the pricing of its debt securities.

Funding Cost and Market Access

• Interest cost:
  Higher-rated borrowers pay lower spreads over benchmark yields. For a given maturity, the yield curve typically shows:

  • Lowest yields for default risk‑free government bonds.
  • Higher yields for investment‑grade corporates.
  • Even higher yields for speculative‑grade issuers.

  A downgrade generally increases the spread required by investors on both new and outstanding bonds.

• Market access:
  Many institutional investors (such as pension funds, insurance companies, and certain mutual funds) are restricted to investment‑grade securities. If an issuer is downgraded below investment grade:

  • Some investors may be forced to sell its bonds.
  • The pool of potential buyers shrinks, reducing market liquidity.
  • The issuer may find it easier to borrow from banks or private lenders than in the public bond market, often at higher cost and with tighter covenants.

• Short‑term funding:
  Commercial paper (CP) markets are highly sensitive to short‑term ratings. Loss of an acceptable short‑term rating can cut off access to the CP market, forcing an issuer to use backup bank credit lines at higher cost.

Covenants, Security, and Maturity

As credit risk rises, lenders typically respond by tightening contractual protections:

• Stronger covenants (for example, limits on additional borrowing, asset sales, or dividends).
• More secured debt, where specific assets serve as collateral.
• Shorter maturities to reduce uncertainty.
• Higher coupons or fees.

For high‑yield borrowers, senior secured loans and bonds may become the dominant funding source, often issued through bank syndicates or specialist investors.

Trading and Spread Risk

The trading of debt securities in secondary markets is also affected by ratings:

• A downgrade, particularly from investment grade to speculative grade, often leads to:

  • Wider credit spreads.
  • Lower bond prices.
  • Increased trading volumes as constrained investors rebalance.

• Even without a rating change, negative news or weaker-than-expected results can widen spreads as investors reassess the issuer’s fundamentals.

This is spread risk: investors can suffer capital losses even when the issuer does not default, simply because the market demands a higher risk premium.

Worked Example 1.2

A large manufacturing company is considering issuing a new 5‑year bond. Its current long‑term credit rating is BBB. Management is evaluating how a potential downgrade to BB+ might impact its funding cost and access to investors. Explain the likely effects.

Answer:
A downgrade from BBB (investment grade) to BB+ (speculative grade) is significant because it moves the issuer below the investment‑grade threshold. Investors would likely demand a higher spread over the benchmark yield, increasing the coupon rate on new bonds. Depending on market conditions, the spread increase could be 100–200 basis points or more. Many institutional investors with investment‑grade mandates would be unable to hold the company’s bonds, reducing demand and potentially causing forced selling of existing issues. New funding would likely come from a smaller group of high‑yield investors, who may insist on tighter covenants, more security, or shorter maturities. Overall, the company’s cost of debt would rise and its flexibility in accessing capital markets would decline.

CFA-RATINGS AND ISSUER CREDIT ANALYSIS IN PRACTICE

Main Issuer-Specific Credit Risk Factors

While macroeconomic and market conditions (for example, interest rates, GDP growth, and risk appetite) influence all bonds, issuer‑specific factors drive relative credit quality. Key considerations include:

• Industry risk:
  Some sectors are inherently riskier than others. Cyclical industries (such as autos, construction, or airlines) tend to have volatile cash flows and are more vulnerable in downturns. Defensive industries (such as regulated utilities) usually have more stable demand and may support higher indebtedness.

• Business profile:
  Scale, market share, and diversification are critical:

  • Larger firms with strong brands, broad product lines, and diversified geography typically have more stable cash flows.
  • Niche players or firms reliant on a single product or customer are more vulnerable to shocks.

• Management and governance:
  Prudent management and strong corporate governance reduce credit risk. Factors include:

  • Credible strategy and conservative financial policy.
  • Transparent reporting and risk management.
  • Alignment of management incentives with long‑term creditor interests.

• Financial profile:
  Analysts focus on:

  • Level and trend of EBITDA margin and returns on capital.
  • Cash flow adequacy relative to interest, debt maturities, and capital expenditure.
  • Liquidity buffers, including cash balances and committed bank lines.
  • Stability of cash flows through economic cycles.

• Event risk:
  Event risk arises from discrete actions that can rapidly alter credit quality, such as:

  • Large debt‑financed acquisitions.
  • Debt-financed buyouts.
  • Major legal or regulatory fines.
  • Asset write‑offs or restructuring.

Key Term: event risk
Event risk is the risk that a sudden, material corporate action or external event—such as a takeover, large acquisition, or legal judgment—significantly alters an issuer’s credit profile.

Rating agencies explicitly consider event risk in their assessments and may adjust ratings or outlooks if they believe management’s strategy increases the probability or impact of such events.

Limitations and Judgment in Credit Analysis

Credit analysis is not a mechanical exercise. Financial ratios are helpful but must be interpreted in context:

• Industry differences:
  Acceptable debt levels depend on business risk. A regulated utility can often support higher Debt/EBITDA than a highly cyclical commodity producer.

• Accounting differences:
  Differences between IFRS and US GAAP, or accounting choices (for example, how leases are classified), can affect reported metrics. Analysts often make adjustments to improve comparability.

• Business model nuances:
  High‑growth companies may report negative free cash flow because they reinvest heavily, yet still be creditworthy if they have strong margins, substantial cash reserves, and access to capital.

• Rating agency limitations:
  As discussed earlier, ratings can lag market prices. Some risks—such as litigation, environmental liability, or fraud—are difficult to quantify and may not be fully captured in ratings until late.

Worked Example 1.3

A high‑growth technology company has negative free cash flows and significant cash reserves. Its interest coverage is low, and Debt/EBITDA is above the sector’s typical range. A credit analyst is asked if it deserves an investment‑grade rating. How should the analyst think about this situation?

Answer:
High indebtedness and low interest coverage are negative indicators for credit quality, even if the company holds large cash balances. An investment‑grade rating generally requires stable, predictable cash flows and comfortable coverage of interest and principal. In this case, the company’s negative free cash flow suggests it relies on external financing to support growth, which increases refinancing risk. While cash reserves provide a temporary buffer, they can be quickly depleted if cash burn remains high. Unless the company can demonstrate a consistent track record of stable operating cash flow and a credible plan to reduce indebtedness, rating agencies are more likely to assign a speculative‑grade rating, despite strong growth prospects or asset backing.

Exam Warning

Do not assume that size or past profitability ensures a high rating or low credit risk. Large, well‑known companies have defaulted when indebtedness increased sharply or industry conditions deteriorated. Always analyze current debt levels, liquidity, and cash flow trends, and consider how resilient the business would be in a downturn.

Revision Tip

Focus on understanding the linkage between business risk, financial risk, and credit ratings. Practice applying key ratios to simple numerical examples and think through how changes in debt levels or coverage would likely affect funding costs and rating outcomes.

Summary

Credit analysis and ratings allow investors and issuers to assess, price, and manage credit risk. Ratings summarize analysts’ opinions on creditworthiness and significantly affect both the cost and availability of funding. At Level 1, you should understand the main types of credit risk (default, downgrade, and spread risk), the key elements of business and financial risk analysis, and the most common credit ratios. You should also be able to interpret rating scales, distinguish between investment‑grade and speculative‑grade debt, and explain how rating levels and changes influence issuance terms, trading prices, and investor behaviour. Recognizing the limitations of ratings and the importance of forward‑looking judgment is essential in applying these concepts in fixed‑income and corporate finance questions on the exam.

Key Point Checklist

This article has covered the following key knowledge points:

• Define credit risk and explain default risk, downgrade risk, and spread risk.
• Describe the main components of credit analysis: business risk, financial risk, and structural risk.
• Identify and interpret key credit ratios related to profitability, indebtedness, coverage, and cash flow.
• Explain how rating agencies assign issuer and issue ratings and how rating scales are structured.
• Distinguish between investment‑grade and speculative‑grade ratings and understand the term “fallen angel.”
• Analyze how ratings and rating changes affect funding cost, market access, covenants, and secondary‑market pricing.
• Recognize issuer‑specific risk drivers, including industry characteristics, management quality, and event risk.
• Appreciate the limitations of mechanical ratio analysis and credit ratings and the role of analyst judgment.

Key Terms and Concepts

• credit risk
• credit rating
• credit spread
• probability of default (PD)
• loss given default (LGD)
• expected loss
• default risk
• downgrade risk
• spread risk
• business risk
• financial risk
• structural risk
• covenant
• indebtedness
• coverage ratio
• EBITDA
• issuer rating
• issue rating
• investment grade
• speculative grade
• downgrade
• fallen angel
• rating outlook
• event risk