Credit & Distressed Analysis

Learning objectives

You will be able to:

1. Adopt the debt investor's lens. Articulate the payoff asymmetry of a fixed claim (capped upside, full downside), explain why that asymmetry makes creditors risk-first readers, and state where a lender's questions diverge from an equity holder's on the same set of statements.
2. Decompose a credit spread into its economic parts: risk-free rate + expected loss (PD × LGD) + a risk/liquidity premium. Compute a corporate bond's spread over the sovereign benchmark from its yield, apply the credit triangle (spread ≈ PD × LGD) in both directions, and estimate a bond's price move from a change in spread using spread duration.
3. Build and read the coverage and leverage ladders: Debt/EBITDA and Net Debt/EBITDA, EBITDA/Interest and (EBITDA − capex)/Interest, FFO/Debt and RCF/Debt. Define FFO and RCF cleanly, adjust leverage for capitalised leases under Ind AS 116 / IFRS 16, and know why FCF and cash conversion outrank any single accrual-based ratio.
4. Distinguish maintenance from incurrence covenants, read the core negative covenants of an indenture (negative pledge, restricted payments, debt incurrence, asset sales, change-of-control), compute covenant headroom and the EBITDA decline that trips a maintenance test, and explain why covenants are an equity issue (they transfer control before insolvency does).
5. Run a priority-of-claims waterfall for both an Indian IBC Section 53 liquidation and a US absolute-priority restructuring, compute the recovery percentage for each class of claimant, identify the fulcrum security where value breaks, and distinguish structural from contractual subordination.
6. Reconstruct a rating the way Moody's and CRISIL do: separate business risk from financial risk, apply a weighted scorecard to reach a standalone credit profile, then notch for parent or sovereign support. State too the known limits of ratings (lag, issuer-pays conflict, the AAA-to-D cliff) with the IL&FS precedent in mind.
7. Read the early signals of distress: spread and price thresholds, the maturity wall, covenant breaches, rating actions, the credit market repricing a name's paper before its equity accepts it. Describe the restructuring toolkit (amend-and-extend, debt-for-equity, DIP financing, cramdown) at a level that lets an equity analyst price refinancing risk before it becomes a headline.

Prerequisites & connections

Builds on. Phase 1's statements (the balance sheet is now a priority stack, not just assets = liabilities + equity; the cash-flow statement is now a debt-service test). Phase 2 entirely: M2.04 (CFO, FCF, cash conversion, the raw material of every coverage ratio), M2.05 (benchmarking, since spreads and leverage only mean something cross-sectionally), M2.06–M2.08 (quality of earnings; a lender who trusts an inflated EBITDA lends against a number that isn't there, and IL&FS, DHFL, Yes Bank, and Cox & Kings from the forensic capstone are credit failures first). Phase 3's valuation and cost of capital (the cost of debt you plug into a WACC is a credit spread; enterprise value is what the waterfall distributes). From Phase 1: M1.09 (consolidation, where structural subordination lives in the gap between standalone and consolidated debt) and M1.10 (the auditor's report, CARO, and the security and charge disclosures).

Feeds into. The sector playbooks (every sector has a characteristic capital structure and a characteristic way of dying: banks and NBFCs on ALM mismatch, infrastructure on refinancing, commodities on the cycle). The rapid-analysis teardown (a ten-minute solvency screen is this module compressed). Portfolio construction and risk (position sizing against downside, not just expected return). And directly into any distressed, special-situations, or high-yield mandate, for which this is the entry gate.

The one-sentence version of this module. Equity is a call option on the enterprise value struck at the total debt; what follows teaches you to value and police the debt, the thing that sets the strike, writes the rules, and takes the keys when the option expires worthless, so that you understand the company as its most senior, most skeptical, and most contractually powerful investors do.

11.1 The debt investor's lens: why credit sees risk first

Start with the payoff, because the payoff explains the psychology, and the psychology explains the entire discipline. An equity holder owns the residual: after everyone senior is paid, whatever is left, however large, is theirs, and their upside is uncapped. A lender owns a fixed claim: they are promised par plus a coupon, no more, ever. If the company triples in value, the lender still gets par plus coupon. If the company halves, the lender may get par plus coupon, or may get thirty cents on the rupee in a liquidation three years from now. The creditor's return distribution is short a put: a thin sliver of upside (the spread they earn if nothing goes wrong) against a fat tail of downside (the loss if it does).