6.5 Fixed-Income: Credit risk and analysis Flashcards
Credit risk
the exposure to potential losses that lenders face due to the possibility of a borrower defaulting on interest or principal payments
Cs of Credit Analysis
bottom-up factors
Capacity is the borrower’s ability to make timely payments on its debt obligations.
Capital refers to the resources at an issuer’s disposal to reduce its reliance on debt. Like capacity, this is a relatively quantifiable factor
Collateral analysis is an assessment of the quality and value of the assets on an issuer’s balance sheet that can be used to support its indebtedness.
Covenants are contractual terms that lenders use to protect themselves against the possibility of managerial decisions that benefit shareholders at their expense.
Character analysis scrutinizes the quality of an issuer’s management team and seeks evidence of red flags, such as a previous use of aggressive accounting policies, fraudulent activities, or poor treatment of bondholders. Like collateral and covenants, this is a more qualitative factor.
Cs of Credit Analysis
top-down factors
Conditions include overall macroeconomic factors (e.g., GDP growth, inflation) that impact the ability of all borrowers to service their debt obligations.
Country considerations include both the geopolitical environment and the domestic legal system’s record of upholding bondholder’s rights.
Currency is a consideration whenever returns can be affected by fluctuating exchange rates, such as when issuers borrow in international markets.
Credit risk can be quantified in a single metric known as
expected loss (EL)
expected loss (EL)
the probability-weighted amount that a lender can expect to lose on a debt investment
expected exposure (EE) or exposure at default (EAD)
The value of an investor’s claim
typically calculated as the bond’s face value net of the value of any collateral that has been pledged.
The two factors that determine expected loss are:
Default risk
Loss severity
Default risk
The likelihood that a borrower defaults on its obligations.
This component of credit risk is quantified by the probability of default (POD).
Loss severity
The percentage of an investment that an investor expects to lose if a borrower defaults, which is calculated as one minus the recovery rate (RR)
When expressed in currency terms, this is measured as the loss given default (LGD), which is calculated as the product of loss severity and expected exposure.
The credit rating industry is dominated by three major agencies
Moody’s, Standard & Poor’s, and Fitch
Credit migration risk
the possibility that a borrower’s credit rating will be lowered
Credit ratings provide several benefits for the financial system:
Investors and issuers use credit ratings to comply with statutory, regulatory, and contractual requirements.
Issuers pay the agencies to rate their debt because many investors are unwilling to hold debt that has not been rated.
Investors benefit from this third-party analysis, which facilitates comparisons of bonds across issuers and sectors and helps with bond valuations.
Despite the valuable analysis that credit rating agencies provide, investors tend to avoid relying exclusively on their assessment for the following reasons:
Credit ratings are “sticky” because they change relatively infrequently, whereas market-determined credit spreads fluctuate daily. Rating also lag the market because agencies tend to maintain existing ratings even after market conditions indicate that a change is justified.
Speculative-grade bonds that carry the same rating often trade at different yields because agencies base their ratings on assessments of expected loss, whereas market pricing of distressed debt is more influenced by estimates of default timing and recovery rates.
Certain risks are difficult to quantify and capture in a credit rating, such as the risk of litigation, natural disasters, and changes in capital structure. Agencies can have very divergent assessments of companies with complex risk exposures.
Agencies can fail to anticipate significant changes, such as as the collapse of the subprime mortgage market that triggered the 2008 Global Financial Crisis.
In addition to credit migration risk, why do corporate bond investors face spread risk?
due to macroeconomic factors, market factors, and issuer-specific factors.
Despite their greater risk, high-yield bonds offer several benefits for investors.
Portfolio diversification: Historically low correlations with investment grade bonds and risk-free yields on government bonds.
Capital appreciation: High-yield bonds are more sensitive to the economic cycle than investment grade bonds, benefiting more from narrowing spreads during expansions.
Equity-like returns with lower volatility: While offering equity-like opportunities for capital appreciation, high-yield bonds exhibit comparatively low volatility due to the income component of their total return.
Market liquidity risk is reflected in transaction costs incurred when a bond is traded, specifically the bid-ask spread quoted by dealers.
These spreads are primarily influenced by two issuer-specific factors:
Issuer size: Bid-ask spreads are lower for the debt of issuers with more debt outstanding.
Credit quality: A wider spread will be quoted on the debts of less creditworthy borrowers, which trade less frequently than bonds issued by issuers with higher credit quality.
Qualitative Factors when in Sovereign Credit analysis
Government Institutions & Policy
Fiscal Flexibility
Monetary Effectiveness
Economic Flexibility
External Status
Sovereign immunity
a legal principle that limits the ability of lenders from enforcing their claims in the same way that they would with a corporate issuer.
When a sovereign issuer is unwilling to pay, the International Monetary Fund may work with investors to restructure the country’s debts.
Fiscal Flexibility
Sovereign issuers can reduce their borrowing costs by maintaining a disciplined approach to managing public finances over the economic cycle.
This includes tax policies that generate sufficient revenues and prudent spending.
Monetary Effectiveness
Central banks use short-term interest rates and reserve requirements to influence the quantity of money and availability of credit in an economy.
The primary monetary policy objective is to achieve price stability.
Central bank independence is important to protect against political pressure to monetize government debt, which puts upward pressure on inflation and reduces the value of the domestic currency.
Economic Flexibility
Indicators of economic flexibility include income per capital, growth potential, and robust trading relationships.
Economic diversification is important to prevent over-reliance on a single industry for tax revenues and sensitivity to commodity price fluctuations.
