Fixed income: Intro to Credit Risk

Question 1

Credit risk

Answer 1

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.

Question 2

default risk

Answer 2

quite obvious: the probability that the issuer fails to pay interest or principal when due

Question 3

loss severity

Answer 3

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

Question 4

expected loss

Answer 4

expected loss = default risk x loss severity

Question 5

recovery rate

Answer 5

recovery rate = %age of bond’s value that investor will receive if the issuer defaults

Question 6

If the yield spread is wide, then bond price is

Answer 6

lower

Question 7

if yield spread is narrow, then bond price is

Answer 7

higher

Question 8

credit migration risk (downgrade risk)

Answer 8

credit migration or downgrade risk is the possibility that spreads will increase b/c the issuer has a credit downgrade

Question 9

market liquidity risk

Answer 9

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

Question 10

pari passu

Answer 10

All debt at a given level (usually unsecured debt ) is said to rank pari passu (equal footing), or have same priority of claims.

Question 11

investment grade rating

Answer 11

Bonds with ratings of Baa3 (Moody’s)/BBB- (Fitch and S&P) or higher are considered investment grade bonds

Question 12

non-investment grade ratings

Answer 12

Bonds rated Ba1/BB+ or lower are considered non-investment grade (aka junk bonds)

Question 13

Notching

Answer 13

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.

Question 14

Risks of relying on ratings from credit agencies

Answer 14

• 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)

Question 15

4 C’s of credit analysis

Answer 15

• Capacity - Collateral - Covenants - Character

Question 16

Capacity

Answer 16

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

Question 17

Collateral

Answer 17

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.

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Question 18

Covenants

Answer 18

 

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.

Question 19

Character

Answer 19

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

Question 20

yield spread

Answer 20

yield spread = liquidity premium + credit spread

Question 21

Factors that influence the level and volatility of yield spread

Answer 21

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

Question 22

Credit analysis for high yield

Answer 22

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