Module 47.1: Credit Risk and Bond Ratings Flashcards
What is credit risk? What are the two main components?
the risk associated with losses stemming from the failure of a borrower to make timely and full payments of interest or principal.
1) default risk - fails to pay interest or principal when due
2) loss severity - amount of loss given default
What is the expected loss and how is it calculated?
default risk multiplied by the loss severity
What does the size of a spread mean for the issuer?
it reflects the credit worthiness of the issuer and the liquidity of the market for its bonds
What are the two main areas of risk that can widen an issuers credit spread?
1) credit migration risk - the possibility that spreads widen because the issuer is less creditworthy
2) risk of receiving less than market value when selling a bond is reflected in the size of the bid-ask spreads.
what is a corporate family rating vs. a corporate credit rating?
ratings on issuers are family ratings and then specific tranches are corproate credit ratings.
What is the investment grade / junk threshhold for Moody’s and Fitch?
anything that is below Ba1 or BB+ is considered junk
What is “notching” and what causes it?
notching is when an agency gives a specific tranche a different rating than the issuer, can be driven by seniority of the bonds and its impact on potential loss severity.
What are the four major risks of relying on credit ratings from agencies?
1) credit ratings are dynamic - change over time
2) rating agencies are not perfect - subprime mortgages given higher ratings then they deserved
3) event risk is difficult to assess - company or industry specific risks are hard to predict
4) credit ratings lag market pricing - prices and yields can change faster than ratings
What are the four cs of credit analysis?
capacity, collateral, covenants, character.
What is capacity for credit analysis (four c’s)?
refers to the borrower’s ability to repay its debt obligations on time. entails three levels of assessment:
1) industry structure - porter’s five forces
2) industry fundamentals
- cyclicality
- growth prospectus
- published statistics
3) company fundamentals
- competitive position
- operating history
- management’s strategy and execution
- ratios and analysis
What is collateral for credit analysis (four c’s)?
determines the market value of assets that will be collateral. Includes:
1) intangible assets
2) depreciation - high dep expense may signal that management not investing properly
3) equity market cap
4) human and intellectual capital
What is covenants for credit analysis (four c’s)?
affirmative covenants - requires issuer to take certain actions
negative covenants.- prevents the issuer from taking certain actions.
Too many covenants may be restrictive and hurt the chances for repayment
What is character for credit analysis (four c’s)?
refers to managments integrity and its commitment to repay the loan.
1) soundness of strategy
2) track record for success
3) accounting policies and tax strategies
4) fraud and malfeasance record
5) prior treatment of bondholders
