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CFA L1 > Fixed Income: Credit Risk & Analysis > Flashcards

Fixed Income: Credit Risk & Analysis Flashcards

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1
Q

What is Credit Risk?

A

It is the risk associated with losses to f ixed income
investors stemming from the failure of a borrower to make payment of interest or principal ie. failure to service their debt

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2
Q

What is default?

A

When a borrower fails to service their debt, they are said to be in default.

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3
Q

Key Drivers of Credit Risk

A

Specific to Borrower (Bottom Up)
Relating to General Economy (Top Down)
Referred to as C’s of Credit analysis

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4
Q

Bottom-up credit analysis factors

A
  1. Capacity: The borrower’s ability to make their debt payments on time.
  2. Capital: Other resources available to the borrower that reduce reliance on debt.
  3. Collateral: The value of assets pledged to provide the lender with security in the event of default.
  4. Covenants: The legal terms and conditions the borrowers and lenders agree to as part of a bond issue.
  5. Character: The borrower’s integrity and their commitment to make payments under their debt obligations.
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5
Q

Top-down credit analysis factors

A
  1. Conditions: The general economic environment that affects all borrowers’ ability to make payments on their debt.
  2. Country: The geopolitical environment, legal system, and political system that apply to the debt.
  3. Currency: Foreign exchange fluctuations and their impact on a borrower’s ability to service foreign-denominated debt.
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6
Q

Secured Corporate Debt

A

Backed by operating cash flows and investments of the business plus cash flows generated from collateral specifically pledged as security for the debt.

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7
Q

Unsecured Corporate Debt

A

Backed by operating cash flows and investments of the issuer, also maybe secondary sources such as asset sales etc

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8
Q

Sovereign Debt

A

Backed by tax revenue, tariffs, and other fees charged by the issuing government. Secondary sources: additional debt issuance, privatization

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9
Q

Illiquid v Insolvent

A

Illiquid - unable to raise cash to service debt
Insolvent: assets of issuer < value of debt
Both may default

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10
Q

Cross Default Clause

A

If the borrower defaults on one type of debt, he is considered to have defaulted on all debts

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11
Q

Pari-Passu Clause

A

All bonds of a certain type rank equally in the default process

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12
Q

Expected Loss

A

=Probability of Default x loss given default
-Probability - annualized
-Loss given default - % or monetary amount

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13
Q

Expected Recovery Rate

A

The proportion of a claim an investor will recover if the issuer defaults.

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14
Q

Loss severity

A

The proportion an investor will not recover, or one minus the recovery rate

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15
Q

Expected Exposure or Exposure at Default

A

Difference between the amount the investor is owed (Principal + Accrued Int) and the value of the collateral available to repay the investor

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16
Q

Loss given Default

A

LGD% = Expected Exposure x (1-Recovery Rate)
= Expected Exposure x Loss Severity

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17
Q

Credit Spread

A

apx= Probability of default x LGD%

If Actual Credit Spread > above est: Investor is more than fairly compensated for the credit risk of the investment and vice versa

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18
Q

How to assess probability of default?

A

Capacity to repay:
- High EBIT Margin
- A high interest coverage ratio (EBIT/Interest)
- Low Leverage Multiples (Debt/EBITDA)
- High Ratio of Cash Flow to Net Debt

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19
Q

How to assess Loss given default?

A
  • whether bond is secured/unsecured
  • level of seniority
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20
Q

When will a high yield bond have lower probability of default than an investment grade bond?

A

When High Yield Bond is secured and Investment grade bond is unsecured and there is deterioration in issuer’s financial situation

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21
Q

Credit Rating Agencies

A

Assign forward-looking ratings to both the issuers of bonds and their debt issues, based on qualitative and quantitative credit risk factors.

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22
Q

Use of Credit Ratings

A
  • Comparing the credit risk of issuers across industries and bond types, and assessing changing credit conditions over time.
  • Assessing credit migration risk
  • Meeting regulatory, statutory, or contractual requirements.
23
Q

Credit Migration Risk

A

the risk that a credit rating downgrade will decrease the value of the bonds and potentially trigger other contractual clauses.

24
Q

Investment Grade Bonds Ratings

A

AAA to BBB- (S&P)
or Aaa to BAA3 (Moody’s)

25
Q

Non-Investment Grade Bonds Ratings (High Yield/Junk Bonds)

A

BB+ to D (S&P)
or Ba1 to C (Moody’s)

26
Q

Risks of relying on Ratings from Credit Rating Agencies

A
  • Credit ratings lag market pricing
  • Some risks are diff icult to assess (litigation, natural disasters)
  • Rating agencies are not perfect (2008 crisis)
27
Q

Split Ratings

A

the same debt issue gets assigned different ratings from different agencies.

28
Q

Credit spread risk

A

The risk that yield spreads widen due to deteriorating conditions, causing credit-risky bond prices to decrease.

29
Q

Macroeconomic Factors

A

In times of strong growth and high pro its, the probability of default decreases, causing spreads to contract; at times of recession, the probability of default increases, causing spreads to widen.

30
Q

Behaviour of Investment Grade & High Yield Bonds

A
  • Investment grade issuers have lower yield spreads than high-yield issuers due to their lower expected loss.
    – During economic contractions (recessions), high-yield and investment grade credit curves rise and latten as the probability of a near-term default increases. The high-yield credit curve may even invert (turn downward sloping) in this stage of the economic cycle.
    – During economic expansions, high-yield and investment grade credit curves fall and steepen as the probability of a near-term default decreases. Credit curves will be lowest and most steep at the peak of the cycle.
  • Across issuers, the dispersion of yield spreads for high-yield issuers is higher than for investment grade issuers.
  • High-yield spreads tend to fluctuate more than investment grade spreads as economic conditions change.
31
Q

Flight to Quality

A

in times of crisis as investors sell riskier assets and buy safer ones in a flight to quality.

32
Q

Incentives for exposure to this higher credit spread risk

A
  • Diversif ication: High-yield bond prices have low or even negative correlation with investment grade bonds, so they can diversify a fixed-income portfolio.
  • Capital appreciation: The larger spread changes for high-yield issues produce larger price gains during economic recoveries compared to investment grade issues.
    3. Equity-like returns: According to some empirical data, high-yield debt offers equity-like returns with lower volatility than equity markets.
33
Q

Systematic factors that can drive yield spreads higher

A
  • Increasing regulations of broker-dealers and market makers in corporate bonds have increased the cost of funding bond positions.
  • Funding stresses in markets may increase risk aversion.
  • Heavy new issuance of debt into bond markets might not be met by increased demand.
34
Q

Issuer Specific Factors

A

For an issuer with problems servicing its debt, yield spreads will be wider than the average for the issuer’s credit rating.

35
Q

Market Factors

A
  • Issuers with more debt outstanding or with higher credit ratings will have more actively traded bonds (and therefore narrower bid–offer spreads) with less market liquidity risk.
  • Bid–offer spreads can widen substantially for high-yield issuers during times of financial stress as market liquidity falls dramatically.
36
Q

Market liquidity risk

A

transaction costs of trading a bond - It can be assessed through analyzing the bid–offer spreads of market makers in a bond.

37
Q

Change in full price of bond using spread change

A

= -ModDuration x Change in Spread + 1/2 convexity x (change in spread)^2

38
Q

Five Qualitative Factors of Sovereign Creditworthiness

A
  1. Stability: Institutions and policy factors
  2. Fiscal flexibility factors: ability to increase tax collection or decrease public spending
  3. Monetary effectiveness factors: ability of the central bank to vary the money supply and interest rates in a credible manner to encourage stable economic growth. A central bank that is independent from the government is less likely to print money to service government debts, reducing the risk of high inflation and currency weakness.
  4. Economic flexibility factors: growth trends, income per capita, and diversity of sources for economic growth.
  5. External status factors: standing of a country’s currency in international markets. reserve currency - better, also consider geopolitical risks relating to conflict
39
Q

Sovereign Immunity

A

Bondholders usually have no legal recourse if a government refuses to pay its debts

40
Q

Three quantitative factors in sovereign creditworthiness

A
  1. Fiscal strength is measured by low debt burden ratios (debt to GDP and debt to revenue) and low interest-to-GDP or interest-to-revenue ratios (which measure debt affordability).
  2. Economic growth and stability is measured by high real GDP growth, large real economy size, high per-capita GDP, and low volatility of real GDP growth.
  3. External stability is measured by high foreign exchange reserves to GDP, high foreign exchange reserves to external debt, low long-term external debt to GDP, and low near-term external debt relative to GDP.
41
Q

Issuers of Non Sovereign Government Debt

A
  1. Quasi Govt Entities - to carry out a government sponsored role ex: infra
  2. Government sector banks or f inancing institutions ex: mission to mitigate climate change
  3. Supranational issuers (WB/IMF) ex: alleviating poverty
  4. Regional governments. These include provinces, states, and local governments (municipal bonds in US) General obligation bonds - unsecured, rely on tax /Revenue bonds ex: toll road
42
Q

Qualitative Factors for Corporate issuers

A
  1. Business model: A corporate issuer with high credit quality will have a business model with stable and predictable cash flows.
  2. Industry competition: Less intensive competition is favorable for an issuer’s credit quality.
  3. Business risk: High-credit-quality issuers have low risk of unexpected deviations from expected revenues and margins.
  4. Corporate governance. An issuer with high credit quality should have suff icient processes in place relating to the fair and legal treatment of debtholders.

Any long term changes should be considered

43
Q

Debt Covenants & Accounting Policies

A

Covenants: For unsecured investment-grade issuers, it is likely that covenants are primarily aff irmative, relating to compliance with rules and laws, maintenance of company assets, and paying taxes. High-yield issuers are likely to have negative covenants, restricting the issuer’s ability to pay dividends or issue further debt, in addition to
af firmative covenants.

Accounting policies. While evidence of fraud is an obvious concern, the use of aggressive accounting policies that accelerate revenue recognition, signi ficant use of off-balance-sheet financing, a heavy preference for capitalizing spending rather than immediate expensing, and frequently changing auditors or the chief financial off icer are also warning signs that the character of management may hurt the creditworthiness of the issuer.

44
Q

Quantitative Factors for Corporate issuers

A
  • Estimating future financial statements and cash lows of the issuer to identify key factors driving their probability of default and loss given default
  • Top-down inputs relate to the macroeconomic cycle, the size of the industry and potential market share, and event risk related to potential external shocks.
  • Bottom- up inputs relate to issuer-specific factors driving revenue, costs, balance sheet assets and liabilities, and future cash flows.
  • Strong operating pro its and recurring revenues
  • Low levels of leverage and less reliance on debt in the capital structure
  • High coverage of debt service payments with periodic income
  • High levels of liquidity to meet short-term debt payments
45
Q

Financial Ratios used in Credit Analysis

A
  • Earnings before interest, taxes, depreciation, and amortization (EBITDA). Drawback: no adjustment for capital expenditures and changes in working capital
  • Cash low from operating activities (CFO)
  • Funds from operations (FFO).
  • Free cash low (FCF)
  • Retained cash low (RCF).
46
Q

Priority of Claims

A

Each different type of bond of a particular issuer is ranked according to a priority of claims in the event of a default. A bond’s position in the priority of claims to the issuer’s assets and cash lows is referred to as its seniority ranking.

47
Q

Secured Debt

A
  • backed by collateral
  • first lien (where a speci fic asset is pledged)
  • f irst mortgage (where a speci fic property is pledged)
  • senior secured debt
  • junior debt
48
Q

Unsecured Debt

A
  • represents a general claim to the issuer’s assets and cash f lows
  • Senior unsecured
  • Senior subordinated
  • Subordinated
  • Junior subordinated
49
Q

Pari Passu

A

All debt within the same category is said to rank pari passu or have the same priority of claims

50
Q

Corporate family ratings (CFRs)

A

Issuer credit ratings are called corporate family ratings (CFRs), and are typically based on their senior unsecured debt,

51
Q

corporate credit ratings (CCRs)

A

issue-speci fic ratings

52
Q

notching

A

the assignment of individual issue ratings that are higher or lower than that of the issuer is referred to as notching. The seniority and covenants (including collateral pledged) of an individual bond issue are the primary determinants of differences between an issuer’s rating and the ratings of its individual bond issues.

53
Q

structural subordination

A

A subsidiary’s debt
covenants may restrict the transfer of cash or assets “upstream” to the parent company before the subsidiary’s debt is serviced. In such a case, even though the parent company’s bonds are not junior to the subsidiary’s bonds, the subsidiary’s bonds have a priority claim to the subsidiary’s cash lows. Thus, the parent company’s bonds are effectively subordinated to the subsidiary’s bonds with respect to the subsidiary’s cash lows.

CFA L1 (16 decks)

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