Special considerations are important when evaluating the creditworthiness of debt issuers in 3 market segments: high-yield corporate bonds, sovereign bonds, and non-sovereign government bonds.
High-yield (non-investment-grade or “junk”) corporate bonds are those rated below Baa3/BBB- by the major rating agencies. Some reasons for these bonds to be rated below investment grade are:
- Highly leveraged capital structure
- Weak or limited operating history
- Negative free cash flow
- Highly cyclical business
- Poor management
- Lack of scale or competitive advantages
- Large off-balance sheet liabilities
- Declining industry (such as newspaper publishing)
A high-yield analysis is typically more in-depth than an investment-grade analysis, and has special considerations, including the following:
- Greater focus on liquidity and cash flow
- Detailed financial projections
- Detailed analysis of debt structure
- Corporate Structure: Parent vs. subsidiaries, cash movement from subsidiary to parent (“upstream”) or vice versa (“downstream”)
- Covenant analysis: Change of control put (right to require the issuer to buy back the debt), restricted payments, limitations on liens and additional indebtedness, restriction on subsidiaries, maintenance covenants
- Equity-like approach
Government bonds in developed countries have traditionally been viewed as the default risk-free rate after which all other bonds are priced. The most important considerations for evaluating debt in sovereign countries, according to S&P’s methodology, are:
- Institutional effectiveness and political risk
- Economic structure and growth prospects: income per capita, trend growth prospects, sources and stability of growth, size of the public sector relative to the private sector
- Flexibility and performance profile
- Monetary flexibility
Non-Sovereign Government Debt
Sub-sovereign or local governments and quasi-government entities that are created by governments such as states and cities issue bonds as well. For example, the City of London has debt outstanding. These are often referred to as municipal bonds.
General Obligation (GO) Bonds
The majority of local government bonds are general obligation bonds. These are unsecured securities backed by the full faith of the issuing non-sovereign government.
GO bonds unable to use monetary policy the way many sovereign governments can. Therefore, these securities carry another layer of risk. Analysts should pay peculiar attention to the volatility and variability of revenues these municipalities generate. Also, these municipalities or states might have unfunded pension and post-retirement obligations which could weaken their creditworthiness.
Municipalities or states might also issue revenue bonds, which are issued to finance a specific project. They carry a higher degree of risk than GO bonds because they are dependent on a single source of revenue – the given project. Therefore, analysts should focus on the projected utilization of the project and its future cash flows.
A key credit measure for revenue bonds is the debt-service-coverage (DSC) ratio, which measures how much revenue is available to cover debt payments after operating expenses.
Which of the following factors in credit analysis is more important for a general obligation non-sovereign government debt when compared to sovereign debt?
A. Per capita income
B. The obligation to balance the operating budget
C. Tax collection performance
The correct answer is B.
Non-sovereign governments are not able to utilize monetary policy and typically must balance their operating budgets. This obligation makes it an important criterion when option for a non-sovereign government.
Reading 55 LOS 55j:
Explain special considerations when evaluating the credit of high yield, sovereign, and non-sovereign government debt issuers and issues