LM 5: Fixed Income Credit Risk & Analysis Flashcards
What is credit risk?
Credit risk is the risk of loss from the borrower defaulting on interest or principal payments.
What are the 5 bottom-up factors of credit analysis, describe them. CCCCC
- capacity (ability of the borrower to make timely payments)
- capital (resources issuer has at disposal to reduce reliance on debt)
- collateral (analyze collateral)
- covenants (protect creditors and give management flexibility.)
- character (analysis considers management’s strategy, track record, use of aggressive accounting policies, etc)
What are the 3 top-down factors of credit analysis, describe them.
- conditions (macroeconomic environment or factors)
- country (reputation of country)
- currency (exchange rates)
What is default risk vs loss severity?
Default risk: The probability the borrower defaults.
Loss severity: The loss given a default occurs.
What is expected loss formula?
Expected Loss = Default Risk × Loss Severity
What is loss severity formula?
Loss Severity = [expected exposure * (1 – Recovery Rate)]
What is credit spread formula?
credit spread = probability of default * loss severity
What is spread risk?
occurs when the interest rate on a loan or bond is disproportionately low compared to another investment with a lower risk of default.
What is credit migration risk?
possibility that a borrower’s credit rating will be lowered.
What is market liquidity risk?
threat of investors being unable to trade bonds without having to sell at a large discount or pay a significant premium
What are the 3 major credit rating agencies?
- moody’s
- standard & poor’s
- fitch
What is the difference between investment grade and non investment grade ratings in terms of credit ratings for credit agency’s?
investment grade is triple B or B double a and better
non-investment grade (aka junk/ high yield) are double b or ba and lower credit ratings
What are the 3 different types of categories of ESG ratings? LAL
- leader (AAA, AA)
- average (A, BBB, BB)
- laggards (B, CCC)
What are 4 risks of relying on agency ratings, describe them?
- Credit ratings are dynamic (i.e., they can change significantly after issue)
- Rating agencies are not infallible (not all fail safe, eg. 2008 crash)
- Ratings may not adequately account for event risk (Event risks are difficult to capture in ratings.)
- Ratings tend to lag the market pricing of risk (The market reacts daily to news of credit risk while rating agencies are slow to make adjustments)
What are the 3 benefits of high-yield bonds to investors? PCE
- Portfolio diversification
- Capital appreciation
- Equity-like returns with lower volatility
Describe the 2 market factors that affect spread risk.
- issuer size (lower bid-ask spread for more debt outstanding)
- credit quality (credit quality will determine the frequency of which bonds trade)
What does high-yield credit analysis focus on compared to investment grade analysis?
investment-grade debt: focus on spread risk—that is, the effect of changes in spreads on prices and returns
high-yield analysis: focus on default risk
What are the 3 quantitative factors considered when analyzing a sovereign government’s credit risk? FEE
- Fiscal Strength
- Economic Growth and Stability
- External Stability
What 2 metrics are used to quantify fiscal strength when assessing a sovereign government’s credit risk? DD
- Debt burden: Debt-to-GDP; Debt-to-Revenue
- Debt affordability: Interest-to-GDP; Interest-to-Revenue
What 2 metrics are used to quantify economic growth & stability when assessing a sovereign government’s credit risk? SG
- Size and scale: GDP in purchasing power parity terms; GDP per capita
- Growth and volatility: Real GDP growth rate; Standard deviation of real GDP growth
What 2 metrics are used to quantify external stability when assessing a sovereign government’s credit risk? CE
- Currency reserves: FX reserves/GDP; FX reserves/External debt
- External debt: Long-term external debt/GDP (External debt burden); External debt due within 1 year/GDP (External debt due)
What is the difference between sovereign debt vs non-sovereign debt?
sovereign debt: governments issue debt to finance general operations
non-sovereign debt: Municipal debt includes issues by state, provincial, and local governments.
What are general obligation bonds?
municipal bonds which provide a way for state and local governments to raise money for projects that may not generate a revenue stream directly, backed by tax revenue
What are revenue bonds?
bonds issued to fund a specific project backed by the projects revenue (eg. Toll roads)
