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Credit analysis evaluates the issuer's ability and willingness to repay debt, examining financial health, industry position, and management quality. The credit spread—the difference between a corporate bond's yield and the risk-free rate—compensates investors for default risk and must be evaluated relative to fundamental credit quality to identify mispriced bonds.
Analyze financial statements of bond issuers, calculate key metrics like debt/EBITDA and interest coverage ratios, and compare resulting credit opinions to market prices.
A corporate bond is a loan from the bondholder to the issuer, and the credit spread — the extra yield above the risk-free rate — is the market's price for the risk that the issuer won't repay. You've already learned that this spread compensates for expected default losses and a risk premium for uncertainty around those losses. Credit analysis is the fundamental work of deciding whether that spread is adequate compensation, too generous, or too stingy relative to the issuer's actual financial health. The goal is to form an independent view of creditworthiness and compare it to what the market implies.
The analysis starts with the issuer's financial structure. The key question is: does this company generate enough cash to service its debt reliably, even under stress? The primary metrics are leverage ratios and coverage ratios. Debt/EBITDA (earnings before interest, taxes, depreciation, and amortization) measures how many years of operating cash flow it would take to pay off the debt — a ratio above 5x is typically considered high for most industries. The interest coverage ratio (EBITDA / interest expense) measures how comfortably operating earnings cover debt service — below 2x is a warning sign. These ratios must always be interpreted relative to the industry: capital-light software companies can sustain lower coverage ratios than utilities with predictable regulated revenue.
Beyond the numbers, credit analysis incorporates qualitative factors. Industry position matters: a market leader with durable competitive advantages can sustain more leverage than a commodity producer with volatile revenues. Management's track record with capital allocation is telling — have they historically used debt prudently, or have they repeatedly levered up for acquisitions? Covenant quality in the bond indenture constrains what management can do with bondholder money. Bond selection then uses this fundamental credit view to identify mispriced securities: if your analysis suggests a company deserves a BB rating but the market prices it like a B, the spread is too wide and the bond is cheap; if you think it deserves B but it's priced like BB, the spread is too tight and you avoid it or sell it.
Practical analysts track trend analysis as carefully as point-in-time levels. A company with 4x debt/EBITDA trending toward 3x over two years is a very different credit than one at 4x trending toward 5x. Similarly, liquidity analysis — cash on hand, available credit lines, near-term debt maturities — determines whether a company can survive a temporary earnings shortfall. The most common credit errors involve being fooled by cyclical peaks: a commodity company looks pristine at $80/barrel oil but faces distress at $40. A good credit analyst stress-tests the financials through a down cycle before concluding a spread is attractive.