A high-yield bond and an investment-grade bond from the same issuer can sit notches apart purely because of where they rank in the capital stack. Credit analysis prices that difference.
- Capacity: ability to generate cash to service debt. The most heavily weighted factor.
- Collateral: asset quality and value pledged or available to bondholders.
- Covenants: affirmative and negative protections in the indenture.
- Character: management track record, strategy, ethics, and bondholder treatment.
KEY: Capacity is quantitative. Character and Covenants are qualitative. Collateral straddles both, the legal pledge is qualitative, the asset value is quantitative.
- Industry structure: competition, cyclicality, regulation, disruption risk.
- Company fundamentals: scale, diversification, cost position, market share.
- Corporate governance: board independence, disclosure quality, related-party dealings.
- Financial policy: target leverage, dividend and buyback discipline, M&A appetite, event risk.
TRAP: A profitable firm in a structurally declining industry is a worse credit than a marginal firm in a stable industry. Industry assessment trumps a single year of margins.
Three proxies in ascending strictness:
Common mistakes
- Conflating issuer rating with bond rating. Issuer rating reflects default probability; bond ratings are notched for recovery. A BB issuer can have a BB+ secured bond and a B+ subordinated bond.
- Reversing leverage direction. Debt/EBITDA lower is stronger; FFO/Debt higher is stronger. Both are leverage measures but invert in formula. Trap: ranking the high-Debt/EBITDA issuer as stronger.
- Treating EBITDA as cash flow. EBITDA ignores capex, working capital, and taxes. An $800M EBITDA firm with $900M capex generates negative FCF.
Bottom line
- Four Cs: Capacity (cash flow, weighted most heavily), Collateral (asset value), Covenants (legal protections), Character (management and financial policy)
- Three ratio families: leverage (Debt/EBITDA, Debt/Capital), coverage (EBITDA/Interest, EBIT/Interest), cash flow (FFO/Debt, FCF/Debt)
- Quantitative factors evaluate the ratios: leverage lower is stronger, while coverage and cash-flow-to-debt are higher is stronger (they invert in formula)
- Qualitative factors can describe a weak credit despite strong ratios. A profitable firm in a declining industry is worse than a marginal firm in a stable one
Exam shortcut
For ratio direction: leverage is "Debt over something" (lower better); coverage and cash-flow-to-debt are "something over Interest or Debt" (higher better). For the bankruptcy waterfall: secured-up-to-collateral, then unsecured pool pari passu, then subordinated, then equity, no class touches the next pool until its own is exhausted. For notching: secured up, subordinated down 1 or 2, the gap widens as ratings fall.
The full lesson (about 1,615 words, 11 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- credit analysis corporate issuers
Browse all free CFA Level I lessons or jump into free CFA Level I practice questions.