Book Review: Opening Credit
Reviewed by William Chew
This book is timely in two respects. First, it arrives at a time when debt markets exceed the size of equity markets worldwide — the authors estimate by a factor of 3 to 1 in the United States based on 2014 data. Second, credit is one of the most important sources of risk for debt investors, yet practitioner-oriented books on this topic remain relatively rare. Many current analyses of credit risk focus heavily on quantitative models rather than fundamental credit analysis.
Opening Credit: A Practitioner’s Guide to Credit Investment aims to provide a full-throated corrective for this gap in the literature. Justin McGowan and Duncan Sankey of Cheyne Capital Management, who have more than 50 years of practice between them, lay out the basic principles of fundamental corporate credit analysis and illustrate the key elements with recent examples. The book focuses on what the authors term “traded credit” — that is, corporate capital market debt issues in developed markets.
Although some of the book’s basic principles can be found elsewhere, McGowan and Sankey make some excellent, original points.
The first step in credit analysis should be to focus not on reported financial results but on management — in particular, the incentives driving management. The authors argue that in most companies, management and its incentives determine both credit quality and changes in credit quality much more than reported numbers do. They note that focusing on management incentives is not typical in most traditional credit analysis. McGowan and Sankey make their case with examples, including Chesapeake Energy and Sallie Mae, in which reported numbers provide little insight into credit quality without attention to management incentives, particularly when conflicts of interest occur between management and investors.
The authors explain that credit analysis should turn to numbers — but only once reported financial results have been adjusted to reflect what McGowan and Sankey call the company’s “economic behavior.” The authors note that even in jurisdictions with relatively rigorous disclosure requirements, such as the United States, companies successfully resist disclosing information key to debt investors. One favorite strategy is to increase the volume of disclosure but not in areas of great importance for credit analysis. For example, some US companies have begun to list an increasing number of risks in their 10-Ks but relegate the discussion of material risks to a brief mention at the end of the filing. Thus, the credit analyst’s job is not simply to work with what is reported but to press the company to disclose key credit information on a timely basis.
With this background, credit analysis must then address the means by which management and its bankers and consultants present the company in the most favorable light possible. Here, McGowan and Sankey discuss in some detail the ways that management can manipulate the main sections of a company’s financial statements. They detail effective methods for dealing with these manipulations, illustrating with examples from US, European, and Asian markets.
Beyond this basic framework, McGowan and Sankey argue that credit analysis is incomplete without attention to areas that can produce investment surprises: off-balance-sheet debt, liquidity analysis, leveraged buyout–related event risk, and the market context for credit. The authors’ discussion of market risk is particularly insightful. They begin by observing that “even the most sound credit analysis may not make you a penny,” reminding readers that market risk may affect expected outcomes significantly and must thus be addressed adequately. The authors end with examples of how relative value analysis addresses market risk.
Opening Credit, although comprehensive, is light in some areas. The focus on credit is largely confined to default risk and does not cover post-default recovery risk, which is important in both speculative-grade and crossover debt issues. Also, the discussion of credit default swaps (CDS) does not include the current evolution of CDS standard contracts to provide for cash rather than physical delivery settlements.
In the end, the book succeeds in its main aim — to offer a useful manual for fundamental corporate credit analysis. It provides a good starting point for both new and more-experienced analysts interested in a current practitioner-oriented guide on this topic.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.