Credit Portfolio management

A quick summary of some core components of top down Credit Portfolio Risk management:

High level diversity:

Ensure the portfolio is diversified by country, obligor size, industry etc and sufficiently uncorrelated. Moodys diversity score is a common metric for measuring correlation in CLOs. Concentrations limits to single obligors/countries/etc. can be used too.

Financials:

Look at Leverage, Debt Service Coverage, Interest coverage, Liquidity/Cash Ratios, Free Cash Flow generation, Managerial Performance (RoE, RoA), Efficiency ratios (Inventory days, Cash Conversion days). Then look at the growth of these variables, then look at the value of these ratios vs competitors (use GICs/SIC Industries or a bespoke grouping) - then use these variables to do two things: (i) Estimate the probability of default (PD) for each firm using a scorecard + (ii) have ratio thresholds that trigger deeper analysis.

Expected Loss:

Take those PDs and calculate a portfolio Expected Loss using LGD/EAD. Or take a leaf out of the CLO world and use a simulation based approach for calculating EL (or VaR), using something called a Copula. Where a simulation is run on the portfolio 1000+ times and assets default at random during the sim, the Copula will make correlated assets more likely to subsequently default in the following time steps of the simulation. 

Earnings Quality:

Monitor for evidence of 'cooking for books'. A few ratios given below, look at the level, growth, or compare to competitors:

• Growth of revenue to receivables (or to FCF): organic sales/cash generation
• Non-recurring expenses vs Revenue: Earnings smoothing evidence/consistent one time expenses?
• Inventory days (or Inventory to Sales): increasing or being much higher than competitors - are sales are slowing?
• Receivables days: increasing or being much higher than competitors: credit being offered for customers, which could result in higher doubtful debtors or returns 
• Intangibles (or Goodwill) to Assets: Asset value inflation 
• OCF to Net Income (or FCF): use of financing cashflows/loan proceeds improving FCF

Industry view/Cashflow projections:

Project the obligor cashflows (apply a stress) to understand if cash runway could be an issue.

Stress each obligor based on expected future revenue growth and gross margin expectations.

Incorporate industry specific ratios in the monitoring process, e.g revenue per available seat mile (airlines), revenue per sqm (physical retail), users (social networks), recurring revenue (Tech), Maritime (Deadweight Tonnage Utilisation)

Events: 

Monitor upcoming events: principal repayments, lease changes, CAPEX schedule, regulatory change. Industry specific items could be: Trial timelines for Pharma

Other things to consider:

• Ensure you capture all adjustments to adjusted EBITDA in a systematic way
• Appreciate differences in accounting standards (e.g. Inventory reversal allowed under IFRS9, but not under USGAAP)
• Dealing with restatement of previous financials