KDP Default Risk Rankings
At the heart of our recommendation system is the KDP Default Risk Ranking. This Ranking measures the probability that the company will default on its obligations over a five-year period. In arriving at this measure, the analyst evaluates the company's potential for generating cash flow, its financial strength and overall liquidity, the strength of its products and business plan, and the prospects for overall growth of the industry in which the company operates. As part of this process, the analyst generates a fully integrated financial model including relevant historical results and a minimum three-year financial forecast for the company.
| High Quality | 1+/1+ | to | 1/3 |
| Above Average | 1/4 | to | 2/4 |
| Average | 2/5 | to | 3/5 |
| Below Average | 3/6 | to | 4/6 |
| Speculative | 5/6 | to | 7/7 |
| Default | - In Default - | ||
| KDP 2 Yr | KDP 5 Yr | Similar Rating | |
|---|---|---|---|
| 1+ | 1+ | Mid - | BBB |
| 1 | 1 | Low - | BBB |
| 1 | 2 | High - | BB |
| 1 | 3 | Mid - | BB |
| 1 | 4 | Low - | BB |
| 2 | 3 | Low - | BB |
| 2 | 4 | High - | B |
| 2 | 5 | Mid - | B |
| 3 | 4 | Mid - | B |
| 3 | 5 | Low - | B |
| 3 | 6 | High - | CCC |
| 4 | 5 | High - | CCC |
| 4 | 6 | Mid - | CCC |
| 5 | 6 | Low - | CCC |
| 6 | 6 | CC | |
| 6 | 7 | CC | |
| 7 | 7 | C | |
| - In Default - | D | ||
Once the Default Risk Ranking is established, the appropriate recommendation is derived by referring to the yield requirements that KDP has assigned to each Default Risk Ranking. Issue-specific yield requirements for a given Default Risk Ranking are adjusted for maturity, seniority, security, and whether the issue is a discount note or PIK (Paid-in-Kind) bond. If the yield on the bond issue in question falls within the required range, it receives a HOLD recommendation; if it is lower than the range, it becomes a SELL; and if it is higher, a BUY. Our investment horizon is long-term, although we also address near-term technical factors where appropriate and relevant.
KDP uses yield-to-worst as the total return measure for the bond issues of any company with a KDP Default Risk Ranking of 1+/1+ through 3/5 (Mid-BBB through Low-B). This is due to the relative likelihood that the company will not default on its obligations, and that the full par amount on these issues will be paid, either at maturity or earlier, depending on the issue call schedule and on the probability of early redemption. For the bonds issued by a company with a KDP Default Risk Ranking worse than 3/5 (High-CCC and lower equivalent), the KDP recommendation is tied to an expected value analysis. This change in methodology is necessary due to the higher probability of default and the increased risk that the issue in question will not reach maturity. Generally, our expected value analysis involves calculating the present value of the bond under two scenarios: a going concern scenario and a restructuring scenario. Probabilities are then assigned to each scenario, based on the probability of default implied by the company's Default Risk Ranking. An expected value of the bond is calculated, and this is then compared to the current price to arrive at the proper recommendation.
Forward Looking 2 Yr. and 5 Yr. horizon
A KDP Default Risk Ranking quantifies KDP's estimation of the chance that a company will default on one or more of its debt obligations. A Ranking of 1+ signifies that default is very unlikely while a 7 signifies that the company is expected to default. The Ranking is further enhanced by reference to a specific time horizon: the first number encapsulates KDP's expectations within a 2-year horizon, whereas the second captures expectations within a 5-year period. On a probability basis, for example, a 2/5 might indicate a 15% chance of default, whereas a 5/6 implies about a 50% chance of default.
Default Risk Ranking Criteria
- 1+/1+ to 1/1
- Very strong interest coverage in the mid-to-high single digit range and a leverage ratio not much higher than 2.0X. Significant asset protection and/or equity cushion. Abundant liquidity supported by high cash balances and/or significant revolver availability and by substantial free cash flow generating ability insuring financial flexibility throughout the business cycle. Free cash flow volatility is either negligible or easily managed given excess liquidity and financial flexibility. Magnitude of debt maturities not a factor. Market leading competitive position and confidence in management. Management committed to prudent balance sheet management. No material adverse change in credit profile expected. Minimal negative event risk.
- 1/2 to 1/3
- Strong interest coverage in the mid-single digit range and a leverage ratio not much higher than 3.0X. Generous asset protection and/or equity cushion. Strong liquidity supported by excess cash balances and/or revolver availability and by strong free cash flow. Capital spending above maintenance levels. Ability to easily monetize assets to preserve longer term financial flexibility. Free cash flow volatility may exist but is not expected to materially impact financial flexibility. The risk of an extended operating downturn is minimal. Magnitude of debt maturities not a material source of concern. Strong competitive position and confidence in management. Improving credit profile. Moderate negative event risk.
- 1/4 to 2/4
- Solid coverage of cash interest in the 3.0X to 4.0X range and a leverage ratio in the 4.0X range. Comfortable asset coverage and/or equity cushion. Solid liquidity and financial flexibility. Free cash flow remains comfortably positive, however access to revolver borrowings becoming a more important source of liquidity and financial flexibility. Free cash flow volatility more of a concern possibly reflecting industry and/or economic cyclicality. Asset sale opportunities or cuts in discretionary capital spending can be relied on to preserve liquidity. Above average competitive position and confidence in management. Debt maturities rising in significance but should be easily managed with revolver borrowings or refinancings. Outlook for credit profile is stable to moderately improving however financial posture is more aggressive and business risk more meaningful, leaving longer term outlook more uncertain.
- 2/5 to 3/5
- Adequate coverage of cash interest in the 2.0X to 3.0X range and a leverage ratio in the 5.0X range. Adequate asset protection or equity cushion. Neutral to moderately positive free cash flow resulting in a material reliance on revolver borrowings to ensure adequate liquidity. Economic and/or industry cycles more likely to have distinct and material impact on operating results. Some financial flexibility and access to credit lines reflecting reasonably good lender relationships and a secured lender exposure generally less than 2.0X. Asset sale opportunities available if needed for near term liquidity enhancement. Average competitive position. Management team may be unproven. Capital spending at or above maintenance levels. Any significant debt maturities are a concern, but should be successfully managed with refinancings. Credit profile is generally stable, but outlook is more uncertain and business risk is considered material.
- 3/6 to 4/6
- Tight coverage of cash interest in the 1.5X to 2.0X range and a leverage ratio in the 6.0X range. Asset protection may not cover total debt, particularly in stress-tested scenario. Limited financial flexibility. Free cash flow is negative or neutral at best. Near term liquidity is tight and bank covenants may be threatened. Bank relationship is tenuous, but lender accommodations are expected given still manageable secured leverage of less than 2.5X and estimated loan to value ratio of not much more than 0.50X. Economic or industry related cyclical downturn may be depressing results and timing behind any rebound is uncertain. Ability to timely complete liquidity enhancing asset sales more in doubt. Debt amortizations are an issue and improvement in operating results may be a prerequisite to any successful refinancing. Capital spending maintained at a low level to alleviate cash squeeze, possibly to the detriment of an already weak competitive position. Credit profile is deteriorating or is expected to stabilize at weak levels.
- 5/6
- Inadequate to tight coverage of cash interest in the 1.0 X range and a leverage ratio of more than 6.0X. Free cash flow is negative and the prospect for positive free cash flow generation in the next 12 to 24 months is very uncertain. Company must reduce costs and/or sell assets to make interest payments. Bank relationship is stressed due to prolonged underperformance or suspect secured asset coverage. Magnitude of debt maturities a major concern. Capital spending is reduced to the degree that it is perceived to affect the company's future performance. Operating improvements necessary for company to be viable. Restructuring is likely in a protracted period of economic or industry weakness.
- 6/6 to 6/7
- Minimal to no financial flexibility. Company not expected to grow into current capital structure. Asset sales may not be enough to alleviate cash shortfalls. Banks unlikely to provide further covenant waivers or amendments. Extreme vulnerability to economic cycle. Recapitalization or restructuring very likely.
- 7/7
- Expected to default.