By guest contributor Jodi Pettersen, Investor Relations, eInvest
The 5 Cs of credit is a simple framework to understand the creditworthiness of an individual, company and even government. These days, credit ratings are used mostly to summarise a corporate’s credit worthiness. But it is worth reviewing the 5 Cs of credit because the fundamentals of lending have not changed. By breaking down credit worthiness into the 5 Cs with the help of Han Solo, we hope to highlight the types of risks our investment managers assess when choosing corporate bonds and credit securities to add to the three eInvest fixed-income ETFs, ECAS, ECOR and EMAX.
Remember, bonds, both corporate and government are essentially loans made by an investor to a borrower. A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. Because the terms of a bond are standardised, they can be traded on the exchange or over the counter (OTC).
As billionaire investor Peter Thiel once quoted: “The whole plot of Star Wars starts with Han Solo having this debt that he owes and so the plot in Star Wars is driven by money”. Let’s analyse the 5 Cs of credit with respect to Han Solo. Is he credit worthy?
Source: 1 ‘Inside Star Wars’ channel on Youtube
First C is Character – does the borrower demonstrate honesty and integrity? While we often say in investment management, ‘past performance is not a reliable indicator of future performance’ when it comes to character the past behaviour of an individual, company or government is considered. If a bond issuer has a history of defaulting, like Han has a history of not paying his gambling debts, they are considered higher risk borrowers and lenders will demand a higher interest rate to compensate for this increased risk. Jabba-the-Hutt charges Han 74,730 credits in interest, or a whopping rate of 33%!
Realistically, stable governments like Australia or the United States can borrow money on the bond market for extremely low rates (less than 1%) as their legal and fiscal stability affords them to be trustworthy borrowers.
Second is Capacity, traditionally this refers to the borrower’s debt to income ratio and their ability to pay the loan back. Given Han’s profession as everyone’s favourite smuggler, it is unlikely he has regular income. For corporates, their financial statements are key in determining capacity. Capacity can also change in response to changing market conditions. Han became a wanted man as the Empire took over and travel, airline and energy companies took a real hit to their capacity to pay back their bonds during the COVID-19 period, with Virgin Australia’s default being a well-known example.
The third C is Capital, this refers to how much money the applicant has, and in the case of corporates and governments, the purpose for which the funds are being borrowed.
Much of Han’s debt relates to gambling, which is an activity that seems to be loss making. His high-risk business dealings make him a risky borrower.
Some credit is taken out to fund specific projects such as the second Sydney airport. With some bond issues there is often no specific project to which the funds raised will be applied. “General corporate purposes”, is frequently the stated use.