A Pragmatist’s Guide to Leveraged Finance: Credit Analysis for Bonds and Bank Debt. 2012. Robert S. Kricheff.
Reviewed by Martin S. Fridson, CFA
With apologies for beginning my review with a cliché, this book fills a conspicuous gap in the finance literature. Over the years, countless aspiring high-yield bond analysts, as well as portfolio managers hiring trainees, have asked me to recommend a how-to book. Until now, only articles and chapters in more general books have provided up-to-date treatments. Nothing as comprehensive as A Pragmatist’s Guide to Leveraged Finance: Credit Analysis for Bonds and Bank Debt has been available.
Robert Kricheff, a seasoned, highly regarded specialist in the field, covers all aspects of risk assessment and valuation of speculative-grade bonds and leveraged loans. In addition to showing how to analyze financial statements of highly leveraged companies, he explains the importance, at the specific issue level, of ranking within the capital structure, covenants, and embedded options. He also outlines the bankruptcy process, focusing on the United States but also touching on other countries. His final chapter stresses the ultimate goal of synthesizing the various threads of analysis to produce a concrete investment decision.
Thanks to his succinct style, Kricheff manages to address a vast array of fine points in a book of moderate length. The reader thus receives guidance on when to use debt/EBITDA and when to look instead at net debt/EBITDA. Kricheff also informs us that analysts now usually adjust EBITDA for noncash compensation. He helpfully points out that commercially available financial databases do not invariably capture these subtleties, making it important to exercise care in using the ratios they generate.
Helpful though these details are, the book’s particular value derives from the judgments Kricheff offers along with the best-practice formulas and procedures. For example, he discusses the widely used relative value ratio “yield spread per turn of leverage” but cautions against relying exclusively on any single measure. Equally sound is his discussion of some high-yield investors’ excessive preoccupation with hard assets. The real credit consideration is economic value. Some physical assets ultimately lose value through technological change, whereas such intangibles as patents and brand names may retain it over long periods.
As its title suggests, this excellent book is about execution of the investment process. Readers seeking a deeper understanding of the high-yield and leveraged loan asset classes must look elsewhere. Kricheff, who heads Credit Suisse’s high-yield sector strategy for the Americas, states at the outset that the book does not delve into theory.
Accordingly, when he speaks of many studies showing that diversified portfolios of speculative-grade debt more than adequately compensate investors for default risk, he does not cite any of those studies. What they actually show is something quite different — namely, a long-run total return premium over default-risk-free Treasuries. That excess return also includes a premium for the comparative illiquidity of high-yield bonds; thus, it is by no means clear that investors are overcompensated for the default-risk component.
If this were a book that delved into theory, it would include an empirically based security market line, with the high-yield asset class resting on or close to it. To the extent that historical performance places high-yield bonds above that famous diagonal, the discrepancy is likely explained by the asset class’s asymmetric distribution of returns, which a simple mean–variance analysis does not take into account. In this case, theory is useful in dispelling the common view among practitioners that high-yield bonds provide some sort of free lunch.
Kricheff also repeats the practitioners’ conventional wisdom that the bond-rating agencies are “backward-looking in their analysis.” Again, he cites no research to support this claim, which seems self-evident to many market participants. To be sure, one can point to numerous instances in which a bond’s risk premium (yield spread over a comparable-maturity government issue) increased in advance of an agency downgrading. Less well remembered by practitioners are the instances in which the spread widened in response to some fear of credit deterioration that ultimately proved unfounded, after which the spread reverted to its previous level while the rating held steady.
The rating agencies certainly do not proclaim a policy of looking backward. In fact, their published rating rationales discuss the issuers’ prospects. Moreover, the agencies supplement their ratings with rating outlooks, which are, by definition, forward looking. It does not require much theory to infer that a lag between a spread change and a rating change reflects the agency’s deliberateness in concluding that an apparent shift in credit quality is permanent rather than a failure by the agency to consider information already in hand. This is another case in which A Pragmatist’s Guide to Leveraged Finance implicitly takes a position on a theoretical issue, even though the author seeks to eschew theory.
A final confirmation of Kricheff’s statement that he is concerned with practice rather than theory is his use of the term job creation. He does not have in mind the customary sense of increased employment in the economy at large but, rather, a head-count rise within a single company. Readers should not make the mistake of inferring that high-yield bond issuance increases overall employment, even though promoters of that asset class made precisely that claim in the 1980s. The late, eminent economist Herbert Stein refuted their argument in a short article that, to the best of my knowledge, remains unanswered to this day.
A few drafting errors mar this generally well-edited text. Affirmative and negative covenants are discussed 13 pages before those terms are defined. Kricheff’s comments on adjusted EBITDA appear on page 56, not, as the index maintains, on page 53. Contrary to what is shown in a table, Moody’s, unlike Standard & Poor’s, has no D rating on its scale; the table also omits S&P’s C rating. In addition, the lower boundary of the investment-grade category should read “BBB–/Baa3” rather than “BBB–/Baa.”
As a distinguished author once remarked to me, nobody has ever written a perfect book. A Pragmatist’s Guide to Leveraged Finance represents the nearest approach to that ideal by any treatise on security-specific analysis of speculative-grade debt. Its contents are essential knowledge for all professionals engaged in that activity.
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