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)
Who can issue general obligation bonds and revenue bonds?
local and regional government authorities
What are the 4 qualitative factors to consider when assessing a corporates credit worthiness? BBIC
- business model
- business risk
- Industry and Competitive Environment
- Corporate Governance
What are the 3 quantitative approaches used when assessing corporate creditworthiness? TBH
- top-down
- bottom up
- hybrid
What 4 quantitative factors must be identified despite the approach used for corporate creditworthiness? PLCL
- Profitability and Cash Flow
- Leverage
- Coverage
- liquidity
What is capital structure?
Capital structure refers to a company’s debt and equity mix
What is seniority ranking?
refers to priority of payment in event of default or payment of cash flows
What is the difference between secured debt and unsecured debt in terms of claims on the issuer?
secured debt: has a direct claim on specific assets owned by the issuer
unsecured debt: has a general claim on the issuer’s assets and cash flow
What are the 7 rankings of seniority from highest ranked to lowest ranked?
- first lien/mortgage
- senior secured (second lien)
- junior secured
- senior unsecured
- senior subordinated
- subordinated
- junior subordinated
What are the first lean/mortgage and second lien seniority rankings backed by?
first lien/mortgage: real property
second lien: pledged assets
In terms of seniority rankings which rankings get secured debt and which rankings get unsecured debt?
secured debt: junior secured and higher
unsecured debt: senior unsecured and lower
What is pari passu in terms of default recovery rate?
all creditors within the same seniority ranking have the same claim in bankruptcy, regardless of the maturity of the debt they hold.
eg. a senior unsecured bondholder with debt due in 6 months is treated the same as a senior unsecured bondholder with debt due in 6 years.
What is the difference between issuer rating and issue rating?
issuer rating addresses the borrower’s overall creditworthiness and business
Issue rating relates to a specific bond issued by the company.
What is the difference between credit analysis and equity analysis?
Equity analysts focus on a company’s upside potential and income statement.
Credit analysts focus on a company’s downside risk and balance sheet.
Does low demand mean wider yield spreads or lower yield spreads?
Low demand means wide yield spreads
Higher demand means lower yield spreads
What is structural subordination?
When corporation has debt at both parent holding company and it’s operating company
What does issuers credit rating usually apply to?
The issuer’s credit rating addresses the issuer’s overall creditworthiness and usually applies to senior unsecured debt.
What is notching?
Notching is when a credit rating agency bumps up or down the credit rating on an issuer’s specific debts or obligations
What is the general rule of notching?
Higher the senior unsecured rating the smaller the notching adjustment
