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Hedge Fund · Topic lesson

Credit

How a credit fund prices and protects a loan: yield to worst, what a spread pays for, covenants, recovery analysis and the fulcrum security.

5 chapters About 50 minutes0 of 5 complete
Start chapter 1

A credit investor's upside is capped: at best, the bond pays its coupons and is repaid. So the job is mostly about the downside: how much you earn for the risk, what warns you early, and what you get back if the company fails. Interviewers test each of those with numbers. This lesson follows a loan from a healthy bond to a restructuring.

  • Yield. What a bond earns at today's price, and to its worst redemption date.
  • Spread. How much of the yield pays for expected losses and how much is premium.
  • Covenants. The tripwires that bring lenders to the table early.
  • Recovery. What each class gets when the company cannot pay.
  • The fulcrum. The class that ends up owning the company.
The rule that solves every question

Follow the queue. Every credit question is about who gets paid, in what order, from what value: interest before dividends, secured before unsecured, and the class where the value runs out takes the company.

A loan, from healthy to restructured

Each step points to the chapter that practices it.

  1. 1
    Price the bond

    Current yield, yield to maturity, yield to worst.

    Chapter 1
  2. 2
    Split the spread

    Expected loss, risk premium, breakeven defaults.

    Chapter 2
  3. 3
    Watch the tripwires

    Leverage and coverage covenants, cures and waivers.

    Chapter 3
  4. 4
    Run the waterfall

    Distressed value paid in strict priority.

    Chapter 4
  5. 5
    Find who owns it

    The fulcrum security and loan to own.

    Chapter 5

Chapters

1

Yield to maturity and yield to worst

11 min

A coupon is what a bond pays; its yield is what you earn at today's price. If the issuer can repay early, quote the yield you can count on.

  • Calculate a bond's current yield and yield to maturity
  • Calculate the yield to call and pick the yield to worst
  • Price a bond from the yield on comparable credits
  • Say when the call, rather than maturity, is the worst case
2

What a credit spread pays for

9 min

A spread covers the losses you should expect, plus a premium for bearing the risk. Split it, and run it backwards to the default rate the market is pricing.

  • Calculate the credit spread and the expected loss
  • Split the spread into expected loss and risk premium
  • Back out the breakeven default rate
  • Show how the recovery assumption changes both
3

Covenants: the lender's tripwires

10 min

Maintenance covenants trip while there is still value to protect. Find which one trips first, whether a fall breaches it, and what a cure or a waiver costs.

  • Find the EBITDA at which each covenant trips, and which binds first
  • Test whether a fall in EBITDA breaches the covenants
  • Size the equity cure for a leverage breach
  • Compare a cure with a waiver
4

Recovery analysis

10 min

When a company cannot pay, what each creditor gets depends on what the business is worth in distress and where the creditor stands in the queue.

  • Value a distressed business and pay its creditors in order
  • Turn a recovery into a fair bond price and compare it with the market
  • Find the enterprise value at which the unsecured recover in full
  • Show how a further fall in EBITDA hits each class
5

The fulcrum security and loan to own

10 min

In a restructuring, the class where value runs out gets the company. Buy it cheaply enough and you are buying the equity at a bond price.

  • Pay three classes in order and find the fulcrum
  • Work out what a loan-to-own stake costs and what it becomes
  • Find the enterprise value at which the fulcrum moves down a class
  • Compare buying the fulcrum with buying the class above it