Why investors should adopt the five Cs of credit

Many years ago, as a young banker, I was introduced to the five Cs of credit (although at the time, it was the four Cs, which later grew to become five). It was a time in which credit ratings were virtually unheard of in Australia, and there was no corporate bond market to speak of.

Yes, there was a market for Commonwealth and state government bonds, but both institutional and retail investors gave little thought to credit risk. The bonds were considered by default ‘risk free' and institutional bond investors were focused exclusively on duration risk, which was a big consideration in the late 70s and early 80s.   

In the absence of credit ratings and credit scoring, the five Cs of credit were used by bankers and other lenders, as a decision-making framework for assessing the creditworthiness of a borrower and the suitability of a loan for the purpose for which it was being sought. These days, it is not clear that whether the five Cs are consciously applied to lending decisions made by banks and institutional investors, and it is likely that the framework is not used at all, by retail investors.

But it is worth reviewing the five Cs of credit because the fundamentals of lending have not changed. No other ways have been invented for lenders to lose money.

What are the five Cs of credit?

1. Character
2. Capacity
3. Capital
4. Collateral
5. Conditions

Applying the five Cs of credit to corporate bonds

Let's consider the application of the five Cs in the context of corporate bond markets: wholesale and retail.

In the wholesale market, institutional investors require bond issuers to have an investment grade credit rating. This requirement provides a measure of creditworthiness from which the required rate of return on the bonds is inevitably determined.

The implication of this is that institutional investors do not conduct their own independent assessment of creditworthiness. Yet, rating agencies consistently state that the rating assigned to an issuer is merely an opinion, and that investors should make their own independent assessment of creditworthiness.

Since the GFC, financial regulators have been singing this tune, long and loud. 

In a small subsector of the wholesale market, sub-investment grade companies issue unrated bonds to middle-market investors such as family offices, charities, churches, hospitals, universities, private schools, endowment funds, and so-called sophisticated investors. The rates of return offered on these bonds are determined by the sponsoring brokers and offered to investors on a take it, or leave it, basis.

Given that it is rare for one of these bond issues to fail, it can only be concluded that many investors do not undertake any form of independent credit risk assessment. Either that or the sponsoring brokers are very good at assessing the creditworthiness of the issuers.

The situation is little different in the retail corporate bond market. New issues are presented on a take or leave it basis, and undertaking their own independent credit risk assessment would not be feasible for most investors in this market.

Investors place significant reliance on the name of the bond issuer: do they know the issuer; is it a familiar and trusted name? And, once more, the return for risk offered by the sponsoring broker(s) is taken at face value.   

Interestingly, name recognition (knowledge of the issuer) is the first and most important of the five Cs. In this respect, retail investors have a major advantage in assessing credit risk, over investors in the subsection of the corporate bond market that is the domain of small, unrated corporate bond issuers.

When considering the first of the five Cs, character, a lender needs to know whether the borrower is trustworthy. Will they do what they say they are going to do, in all respects related to the loan?

Will interest payments be made on time and the principal repaid at the maturity of the loan? Will the money borrowed be used for the stated purpose?

When considering a corporate bond issue, investors should be concerned about corporate governance. Corporate governance determines the behaviour of the company and its officers.

Is the borrower a good corporate citizen? Are there instances where the company has not done the right thing by investors or stakeholders, even though it may have been acting legally?

Has the company been caught up in any scandals? Is it involved in any activities or industries that you, as an investor, would prefer not to be exposed to?

Too often, it seems that character is an afterthought, with more attention paid to the remaining four Cs.

Capacity is about the financial position of the borrower and the borrower's ability to generate sufficient future cash flow to service the loan.

From the financial statements of the borrower, a good assessment can be made of a company's solvency and liquidity. Its profit and loss and cash flow statements will show whether the company is consistently profitable and generates sufficient cash flow to service the bonds to be issued, along with all its existing borrowings.

Capital relates to the purpose of the borrowing. What are the proceeds of the bond issue going to be used for and how much of its own money is the company going to contribute to the project?

This is about having skin in the game. It provides a wonderful incentive to the company to ensure that its project is successful, and that the project will not be abandoned when difficulties are encountered.

However, with bond issues there is often no specific project to which the funds raised will be applied: ‘general corporate purposes' is frequently the stated use.

This simply means the money raised from the sale of the bonds will be used to fund day-to-day activities. In this case, investors need to be satisfied the company itself is sufficiently well-capitalised and is not too reliant on debt to fund its balance sheet.

Collateral provides lenders with a second source of repayment, should a borrower fail to meet its obligations and default on the loan. Collateral is the security offered by the borrower – a charge over land and buildings, plant and equipment, guarantees from a creditworthy third party – which can be sold or called on by lenders to recover their capital and any outstanding interest, when the borrower defaults.

Typically however, few bond issues come with security, and if they do, the security will be shared equally with other lenders, including the company's bankers. Most bond issues are unsecured and can rank behind secured lenders, such as the company's bankers.

Investors need to be satisfied with the adequacy of the security offered or be comfortable with being unsecured or ranking behind other creditors to the company.

Conditions is the fifth C, a later addition to the first four. This refers to the terms and conditions attached to the loan that are either imposed by lenders on the borrower, or in the case of bond issues, are offered by the issuer to investors.

Banks will often impose conditions on corporate loans, particularly where the borrowing is being undertaken for a specific purpose. But more generally, there will be conditions such as maintaining a minimum level of capitalisation, a maximum level of gearing, and a minimum level of interest cover and debt serviceability.

The sale and purchase of significant assets may also be restricted, if not prohibited.

Conditions are less common in bond issues. Financial undertakings in relation to gearing, interest cover and debt serviceability may be offered but often there will be no significant conditions at all.

Investors need to be aware of the conditions offered and decide whether they are satisfactory or not. Where no conditions are offered, investors must be comfortable that they are providing the company with funds that it can use in any way it pleases.

This is where, combined with an absence of collateral, character or corporate governance becomes critical. There must be trust that the borrower will be responsible and honour its obligations to bond holders. This trust should not be misplaced.

The five Cs are fundamental to credit risk assessment

Introductory banking courses still cover the five Cs of credit. The approach to credit risk assessment typically appears early in the course and then the course content moves on to discuss ‘more exciting' topics.

Banking students and practitioners may not think much more about the five Cs thereafter. Focus will switch to assessing the macro-economic environment, industry risk, earnings and cash flow projections and calculating relevant financial ratios.

But why is this information being gathered; where does it sit in the decision-making process?

A similar treatment may be given to the five Cs in finance and investment courses. And of course retail investors may never hear of them, unless they are particularly diligent about managing their own investment portfolios, and do not simply rely on the recommendations of advisors.

Yet, upon reflection, it is clear that the five Cs set out the framework for everything that a lender or investor needs to consciously consider before making a decision. In an era of information overload, application of the framework allows information to be categorised into what is useful for decision-making and what is irrelevant.

In the past, information asymmetry has posed a hurdle for lenders and investors to overcome, and considerable work may have been required to help them do so. And perhaps because of the amount of work involved, the reason for gathering the information was not forgotten, and unnecessary effort was not expended.

Today, with 100-page plus prospectuses, and not to mention the font of all knowledge, the internet, only the most obscure borrowers can remain a mystery to potential lenders. But there may be too much information.

The five Cs set out what a lender/investor needs to know. Consciously applying the framework can only deliver a better outcome through greater decision-making efficiency. 

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The information contained in this column should be treated as general advice only. It has not taken anyone's specific circumstances into account. If you are considering a strategy such as those mentioned here, you are strongly advised to consult your adviser/s, as some of the strategies used in these columns are extremely complex and require high-level technical compliance.