Book 4_Fixed_READING 62_CREDIT RISK Flashcards
Credit risk
refers to the possibility that a borrower fails to make the scheduled interest payments or return of principal.
Bottom-up credit analysis factors
include capacity, capital, collateral, character, and covenants.
Top-down credit analysis factors
include country, conditions, and currency.
A cross default clause
means that a default on one bond issue causes a default on all issues.
A pari passu clause means
all bonds of a certain type rank equally in the default process
Credit risk
measured through expected loss, which is the product of the probability of default and the loss given default
Loss given default expressed as a rate
is also called loss severity, and equals one minus the recovery rate.
LGD% = (1 - recovery rate)
Expected loss as a percentage
is an estimate of the credit spread investors should demand:
credit spread ≈ POD (probability of defaud) × LGD%
Actual credit spread
= bond yield - government security yield
High credit quality with a low probability of default.
A profitable company with high EBIT margin, high interest coverage ratio, low leverage multiples, and high cash flow to net debt
More senior, secured debt
will have a smaller loss given default than junior, unsecured debt.
Credit ratings
reflect a debt issuer or debt issue’s overall creditworthiness and assess the likelihood that debt will be fully paid back.
investment grade and of lower credit risk
Ratings of BBB-/Baa3 and above
non-investment grade (highyield) and of higher credit risk.
Ratings of BB+/Ba1 and below
Investors should not rely exclusively on credit ratings from rating agencies for these reasons:
- Rating agencies cannot always judge credit risk accurately.
- Firms are subject to risk of unforeseen events that credit ratings do not reflect.
- Market prices of bonds often adjust more rapidly than credit ratings.
An issue’s yield spread over its benchmark
reflects credit risk and liquidity risk.
The level and volatility of yield spreads are affected by:
- the credit and business cycles,
- availability of capital from broker-dealers,
- the supply and demand for debt issues,
- and the financial performance of the bond issuer
Yield spreads tend to narrow when
- the credit cycle is improving,
- the economy is expanding,
- financial markets and investor demand for new debt issues are strong
Yield spreads tend to widen when
- the credit cycle, the economy, and financial markets are weakening,
- in periods when the supply of new debt issues is heavy or broker-dealer capital is insufficient for market making.
The liquidity spread
- can be estimated as the difference between yields of a bond at bid and offer prices
- The remainder of the yield spread is considered credit spread.
Given an expected change in spread, duration and convexity can be used to estimate the impact on price:
Change in full price of bond = -ModDur(deltaSpread) + 1/2 x convexity x (deltaSpread)^2
Yield spread = liquidity spread + credit spread
- Calculate yield spread
- Calculate liqudity by the different yield at bid and offer price
- The remaining is the credit spread
