Fixed income: Intro to Credit Risk Flashcards
Credit risk
Credit risk is the risk of loss stemming from the borrower’s failure to repay loan.
Credit risk has two components:
- default risk
- loss severity.
default risk
quite obvious: the probability that the issuer fails to pay interest or principal when due
loss severity
loss severity refers to the value that bondholder will lose if the issuer defaults. Can be stated in monetary amount or %age of bond’s principal value
expected loss
expected loss = default risk x loss severity
recovery rate
recovery rate = %age of bond’s value that investor will receive if the issuer defaults
If the yield spread is wide, then bond price is
lower
if yield spread is narrow, then bond price is
higher
credit migration risk (downgrade risk)
credit migration or downgrade risk is the possibility that spreads will increase b/c the issuer has a credit downgrade
market liquidity risk
market liquidity risk is the risk of being unable to sell the bond quickly and thereby receiving less than market value when selling a bond.
Bid-ask spreads are quite wide. Market liquidity risk is greater for the bonds of less creditworthy issuers
pari passu
All debt at a given level (usually unsecured debt ) is said to rank pari passu (equal footing), or have same priority of claims.
investment grade rating
Bonds with ratings of Baa3 (Moody’s)/BBB- (Fitch and S&P) or higher are considered investment grade bonds
non-investment grade ratings
Bonds rated Ba1/BB+ or lower are considered non-investment grade (aka junk bonds)
Notching
Notching is the practice by rating agencies of assigning different ratings to bonds of the same issuer. Notching is based on several factors, including seniority of the bonds and its impact on potential loss severity.
Risks of relying on ratings from credit agencies
- Credit ratings don’t stay static over time
- Credit agencies can and have been wrong (think 2007)
- Ratings can’t incorporate unpredictable events
- Ratings tend to lag market pricing of risk (Market prices and credit spreads change much faster than credit ratings)
4 C’s of credit analysis
- Capacity - Collateral - Covenants - Character
Capacity
Capacity evaluates the borrower’s ability to pay on time. Capacity analysis entails three levels of assessment:
1) industry structure (think Porter’s 5 forces: threat of substitutes, threat of entry, power of suppliers, power of buyers, rivalry among existing competitors
2) industry fundamentals
- Industry cylicality (cyclical vs non cyclical)
- Industry growth prospects
3) company fundamentals
- mgmt strategy and execution
- operating history
- ratio analysis
Collateral
Collateral involves estimates of market value
Issues to consider when assessing collateral:
- Intangible assets (Patents are easy to sell, goodwill - not so much)
- Depreciation: High depreciation expense relative to capital expenditures may signal that management is not investing sufficiently in the company.
-
Covenants
Affirmative covenants require the borrower to take certain actions, such as paying interest, principal, and taxes; carrying insurance on pledged assets; and maintaining certain financial ratios within prescribed limits.
Negative covenants restrict the borrower from taking certain actions, such as incurring additional debt or directing cash flows to shareholders in the form of dividends and stock repurchases.
Character
Character refers to management’s integrity and its commitment to repay the loan. Factors such as management’s business qualifications and operating record are important for evaluating character.
Character analysis includes an assessment of:
Soundness of mgmt’s strategy
Mgmt’s track record
Accounting policies and tax strategies
Fraud record
Previous treatment of bondholders
yield spread
yield spread = liquidity premium + credit spread
Factors that influence the level and volatility of yield spread
Spread is affected by:
- Credit cycle (credit risk is cyclical: spread narrows as credit cycle improves, spread widens when cycle deteriorates)
- Economic conditions (credit spreads narrow when economy is doing well and widens when economy is shit)
- Financial market performance (credit spread narrows when markets are performing well and vice-versa)
- Broker-deal capital (most bonds are traded OTC so investors need broker-dealers to provide market-making capital for bonds to function
- General market demand and supply
Credit analysis for high yield
Remember, high yield bonds are rated below Baa3/BBB-
For high yield bonds, there’s a greater focus on liquidity (cash flow analysis)
Debt structure -> calculate debt/EBITDA ratio at each level
characteristic: “top heavy capital structure”, less borrowing capacity
- look for structural subordination
