Archive for the ‘Corporate Securities’ Category

Barron’s Confidence Index (BCI)

It is a Confidence Indicator which is calculated by dividing the average yield of X number of high grade bonds on Y number Intermediate/low grade bonds. It is most often used in corporate bonds to gauge investor sentiment. Let’s start with an example.

Let’s say we calculated average yield of 10 AAA rated papers (no option) and 10 A rates papers of 10Y maturity. AAA average yield came in at 8% and A average yield came at 9.5% then confidence index will be calculated as follows:

BCI = (8/9.5)*100 = 84

One can debate why to calculate and get into complexities when we already have spreads. The crux is even if spread is same for two situations, BCI can be different. See below…

BCI

Higher the level of BCI better is the  bond market sentiment and vice versa. The simple theory is when traders are on risk on  they are  likely to invest in speculative papers.

The reason I mentioned X and Y is because experts may believe to take varied number of bonds for their calculation. Rising  BCI is also considered positive for stocks and the same shares a positive correlation with equity markets.

In Indian context BCI is hardly used or say rather hardly published.

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Crowding Out Private Investment

Government borrows to fund its deficit. We often come across something like crowding out of private investment in articles when the writer is talking about government borrowings.  Let’s understand what it means.

Crowding out basically refers to a situation where the private sector gets elbowed out of the debt market due to higher demand for government funds.  Let’s say banks garner Rs.100 via deposit. 23% of the same goes into gilts & SDLs (SLR requirement). 4% of it goes to RBI given CRR is a mandatory liquidity requirement. Balanced fund is then lent to consumer and Industry for their varied needs.  When government increases its borrowing it consequently increases demand of money which in turn increases interest rates. The problem is that the government can always pay the market interest rate, but there comes a point when corporations and individuals can no longer afford to borrow at higher rates. Also Banks then prefer investing in Gilts rather than lending to other non government entities as high interest rates increases risk of default. Thus Private borrowers which includes Industry (Term Loan, Working Capital Loan, Machinery Loan, etc) and Individuals (Personal Loan, Home Loan, etc) finds it difficult to get a loan more importantly at a cheap rate. This fall in investment by Individuals and Corporates affects long term growth thereby impacting a number of macroeconomic indicators like IIP, Unemployment, Inflation, etc

Governments’ borrowing to incremental deposit of banks is a good indicator to measure the crowding out effect.

Gilt borrowing to Incremental deposit

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G-sec corporate bond spread in first half of calendar year

It is the month of Jan, Feb and March when CD issuances rise manifold. Corporates demand funds from banks for working capital requirement. Corporates also buy funds for plant and machinery to enjoy depreciation benefit. Hence banks fall short of money and raise funds via bulk deposit at higher rates amid tight liquidity for funds. Short term rates rises so it is well understood that banks won’t borrow funds at 8.5-9.5% to invest in bonds yielding nearly same return. This reduces demand for corporate bonds and hence spread widens substantially. Soon as and when liquidity improves (which brings down short term rates as well) spread narrows.

Spread

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FII Debt Limit Auction – Details

Refer this latest press release of SEBI (SEBI Circular) on enhanced FII debt limit wherein each head is described to its best. One can understand broadly which securities are included under different segments identified by the watchdog. Auction is scheduled on every 20th. FII debt limit auction could be held on the next working day in case 20th happens to be a holiday. Auctions would be held on recognized exchanges like BSE and NSE if free limits greater than Rs1000 crore are available for any of the three categories — Government Securities (G-Sec), corporate bonds and long-term infrastructure corporate bonds. One has to bid in premium terms. FIIs have to utilize these limits within 90 days in case of corporate debt and long-term corporate infrastructure debt. The time period for utilizing G-Sec limits is 45 days. FIIs bid in bps as premium to actual yield. When they feel bonds are undervalued they probably bid with higher premium and vice versa. If an FII bid for Gsec at 8bps then that signifies that he/she is willing to buy Gsec (which is currently trading at 7.5%) at 7.42%. These figures are not released by the exchange and are difficult to find on SEBI’s portal.  An FII can let the auction limit get lapse but that doesn’t mean that they will be refunded with their bid premium.

Find information on most recent auctions here : BSEINDIA & NSEINDIA

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Factors affecting money market rates {Excel on CBLO-CD allocation attached}

Money market rates move in tandem with liquidity condition in an economy. As far as India is concerned major factors affecting liquidity are
• Currency in circulation
• Government cash balance
• Credit Deposit Growth differential
• Open Market Operations
• FX intervention (spot markets)

Liquidity deficit is structural in nature. Every quarter end heavy chunk is sucked from the system on account of advance tax outflows. Liquidity also marginally gets worse every month end/start as currency in circulation increases on account of salary draw down  Sale of govt. resources also affects liquidity due to cash outflow. Situation of liquidity going forward can be to some extent easily analyzed contemplating above factors. Normally in the month of February and August end fund managers sit on cash awaiting better yield CDs as tight liquidity and heavy supply increases the yield of short term papers. Now they probably work on whether to invest in CD right away at 9.05 %( hypothetical) or wait (i.e. invest in CBLO synonym to cash @7.75% [near to RBI’s REPO rate]) for few days and pick same maturity CD at 9.25%.

Below is the excel sheet wherein one can contemplate and see if it’s better to lock in money in a CD right away or wait for sometime placing the same cash in CBLO.

Download – Money Market Investment Decision

Examples performed

If CD rates after 20days are expected to be at 9.40%. Currently CD is at 9.05%. CBLO is at 7.75% then probably it is better to get into CBLO for 20days then invest in CD @9.40%. Annualized yield would then be 2bps higher comparatively.

If CD rates after 25days are expected to be at 9.40%. Currently CD is at 9.05%. CBLO is at 7.75% then probably it is better to get into CD right away at 9.05%. Annualized yield would then be ~6bps higher comparatively.

Appreciate your inputs…

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Ratios used in Credit Analysis

Financial ratios are a means of evaluating a company’s performance or health using its financial statements. We will discuss few ratios which are predominantly used by credit rating analyst or credit rating agencies to gauge solvency and cash flow related aspects of a business/company. Even an equity investor can use this to test whether a company is effective managing its business. Ratios are classified into different variants. They are:

  • Liquidity Ratio
  • Asset Turnover Ratio
  • Financial Leverage Ratio/Gearing Ratio
  • Profitability Ratio
  • Dividend Policy Ratio
  • Cash Flow Ratio
  • Investment Valuation Ratio

There may be more bifurcation. But for now let’s read above listed ratios. We won’t discuss the non-bold ratios.

  • Liquidity Ratio: Liquidity ratios attempt to measure a company’s ability to pay off its short-term debt obligations.
  1. Current Ratio:

    The concept behind this ratio is to ascertain whether a company’s short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current portion of term debt, payables, accrued expenses and taxes). In theory, the higher the current ratio, the better.

Current Ratio = Current Asset / Current Liabilities

  1. Quick Ratio:

    Quick Ratio is also known as Acid Test Ratio. Quick Ratio is a liquidity indicator that further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to turn into cash. Therefore, a higher ratio means a more liquid current position.

Quick Ratio = (Cash Equivalents + Liquid Investment + Accounts Receivable) / Current Liabilities

  • Gearing Ratio:

    Financial Leverage Ratios provide an indication of the long term solvency of the firm unlike liquidity ratios which are concerned with short term assets and liabilities. It is also said to be a measure of financial leverage, demonstrating the degree to which a firm’s activities are funded by owner’s funds versus creditor’s funds.

1. Debt to Equity Ratio:

The most common Gearing ratio is  Debt-to-Equity ratio. A high Debt-to-Equity ratio is indicative of a great deal of leverage, where a company is using debt to pay for its continuing operations. In a business downturn, such companies may have trouble meeting their debt repayment schedules, and could risk bankruptcy.

Debt – Equity Ratio = Total Debt/ Total Equity

2. Times Interest Earned:

The Times Interest Earned ratio indicates how well the firm’s earnings can cover the interest payment on its debt. It is also known as Interest Coverage Ratio. Higher the ratio better is the business.

Interest Coverage = (EBIT)/Interest & Finance Charges

3. Debt-Asset Ratio:

Debt by Asset ratio here again indicates the level of leverage the business is facing. Higher the ratio more leveraged the business is.

Debt-Asset Ratio = Total Debt / Total Assets

4. Capitalization Ratio: Capitalization ratio again deciphers the financial leverage of a firm.

Capitalization Ratio = (LT Debt) / (LT Debt + Preferred Stock + Equity)

  • Profitability Ratio:

    This ratios show how profitable is the business. These ratios examine the profits made by a firm and compare these figures with the size of the firm, the assets employed by the firm or its level of sales.

1. Gross Profit margin: Gross profit is profit before indirect expenses.  High Margin is preferable.

Gross Profit Margin = Gross Profit / Operating Income

2. Net Profit Margin : This Margin indicates profitability after all cost have been included. High Margin is preferable.

Net Profit Margin = PAT (Profit After Tax) / Operating Income

3. Return on Capital Employed (ROCE) :

ROCE is the % return on the capital invested in the business. It is a ratio which looks at how effectively a company uses its capital. It is often seen as a prime ratio since it provides a direct measure of the main task of management i.e. to maximise the return on capital invested. High number is preferred.

ROCE = PBIT / (Total Debt +Tangible Net worth +Deferred Tax Liability –CWIP)

  • Cash Flow Ratio :

    Cash flow analysis uses ratios that focuses on cash flow and how solvent, liquid, and viable the company is. Here are the most important cash flow ratios with their calculations and interpretation.

1.Fund Flow From Operation / Interest

2.Fund Flow from Operations/Total Debt

3.Retained Cash Flows/Total Debt

The above ratio may vary from industry to industry.

They can be proper used to compare business in same industry as we know ratio of an Infra company would differ with FMCG in terms of above ratios. Higher the above cash flow ratio better the business.

Above note is a result of publicly available information!!

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Altman Z-Score / Zeta Model of Credit Analysis

The Altman zeta model is a formula that predicts whether a company will go bankrupt within the following two years. Generally speaking, any company with a score of 1.8 or lower is in trouble, while a score of 3.0 or higher means the company is safe. If the score is between 1.8 and 3.0, then it is in a danger area; depending on the company’s policies and market fluctuations it could go either way. Given the value of the five variables for a given firm, a Z-score is computed.

Z = 1.2X1 + 1.4X2+ 3.3X3 + 0.6X4 + 1X5

Z: Z score
X1: Working capital/Total assets (in decimal)
X2: Retained earnings/Total assets (in decimal)
X3: Earnings before interest and taxes/Total assets (in decimal)
X4: Market value of equity/Total liabilities (in decimal)
X5: Sales/Total assets (number of times)

Extensive testing has found this formula to be very accurate, as high as 90% in some cases. It works by weighting various aspects of a company’s assets and earnings in order to generate a final score. The original model was designed for certain manufacturing companies, but it has since expanded to cover other areas. In Altman’s original testing, the zeta model was found to have 72% accuracy with a false positive chance of 6%. These numbers made it far more accurate than any other model currently used. Since the initial testing, the model has been put up against a huge number of cases, and it is believed to have an 85% to 90% accuracy rate with a false positive rate of 15 to 20%, still far above other models.

Below is the calculated Z-score based on Zeta model dictated above of Few Indian Real Estate Companies:

Note: Oberoi has zero debt but for some rational Z-Score I have taken a Debt figure of Rs.1crore.

There are said to be few drawback as well:

  • There are only two extremes or say two states i.e. Default or no Default
  • The second drawback is the constant factor weights which few analyst may agree with and few disagree.
  • The model only considers five fundamental quantifiable variables. No Weight for Qualitative information.

Above note is a result of publicly available information!!

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