(R47) Fundamentals of Credit Analysis Flashcards
Define Credit Risk and list the two components
Credit risk is the risk of not receiving full interest and principal payments on a timely basis; Two components include: default risk and loss severity
Default Risk (Probability)
Risk that the issuer or company doesn’t make its required payments (This is the focus of high-quality debt issuers)
Loss Severity
The size of the loss given the event of default (This is the focus of low-quality debt issuers)
Expected loss =
Default risk x loss severity
Downgrade risk
The risk that a bonds issuer’s creditworthiness deteriorates, or migrates lower, leading investors to believe the risk of default is higher (AKA credit migration risk)
Two broad categories of seniority ranking
Secured and unsecured; secured always gets paid first
Secured capital structure includes
First lien/mortgage debt (highest) to senior secured (lowest of group)
Unsecured capital structure includes
Senior unsecured to junior subordinated
Recovery rates vary by the following
- seniority
- industry
- stage of credit cycle
Why would two bonds with equal ratings have different prices?
Due to different recovery rates and different outlook
Two broad categories of credit ratings
- Investment grade (AAA to BBB-)
2. Non-investment grade (BB+ to D)
Issuer credit rating vs. issue credit rating
- Issuer credit rating- Addresses the obligor’s (the company’s) overall creditworthiness (applies to senior unsecured debt).
- Issue credit rating - refers to specific bonds of an issuer
When does issuer credit rating = issue credit rating
When bond rating is AAA only
Investment grade vs. non-investment grade; which has lower default and liquidity premiums?
Investment grade
Notching
- Rating agency practice where specific issues from the same borrower may be assigned different credit ratings;
- Investment grade: Issue is 1 notch +/- issuer (primary focus is the probability of default
- Non-investment grade: issue is 2 notches below issue (primary focus is on the recovery rate
List the four C’s of credit analysis
- Capacity
- Collateral
- Covenants
- Character
These asses the ability to pay and look and credit quality and industry fundamentals
Capacity (4 C’s of credit analysis)
Ability to pay on time; to determine this, look at the industry analysis/structure (porters framework), industry fundamentals, and company fundamentals
Collateral (4 C’s of credit analysis)
Focus is on the estimated loss (1 - recovery rate) and involves estimates of market value
Covenants
Affirmative (mgmt. is obligated to do) vs. negative (mgmt. limited in doing)
Character
Track record, poor strategy and policies, poor treatment of bond holders
Yield on corporate bond =
Benchmark rate + spread
Spread =
liquidity premium and credit spread
Factors that affect credit risk (credit spread)
- Credit cycle
- economic conditions
- financial market performance
- Supply and demand
Special considerations of High Yield Bonds when performing credit analysis
- Non-investment grade (rated below Baa3/BBB)
- More interested in loss severity
- Greater focus on liquidity
- Top heavy capital structure
- structural subordination
Special considerations of Sovereign Debt when performing credit analysis
- Focused on the ability and willingness to pay
- Sovereign governments have immunity and don’t have to pay investors
- Must look at political and economic factors
Special considerations of Municipal debt when performing credit analysis
- Municipalities must balance their budgets
- General obligations bonds (unsecured)
- Revenue bonds (issued for specific projects)
Market liquidity risk
Risk that the price at which investors transact may be different from the price indicated in the market; increased by less debt outstanding and/or a lower credit rating
Debt/capital ratio and debt/EBITDA ratio are what type of ratios?
Leverage ratios; The higher the ratios, the more credit risk
Coverage ratios measure?
Measure an issuer’s ability to meet its interest payments
