Reading 47: fundamentals of credit analysis Flashcards
The two components of credit risk are:
default risk and yield spread.
default risk and loss severity.
loss severity and yield spread.
Credit risk is composed of default risk and loss severity. Yield spreads reflect the credit risk of a borrower. (LOS 47.a)
Expected loss can decrease with an increase in a bond’s:
default risk.
loss severity.
recovery rate.
An increase in the recovery rate means that the loss severity has decreased, which decreases expected loss. (LOS 47.b)
Absolute priority of claims in a bankruptcy might be violated because:
of the pari passu principle.
creditors negotiate a different outcome.
available funds must be distributed equally among creditors.
A negotiated bankruptcy settlement does not always follow the absolute priority of claims. (LOS 47.c)
“Notching” is best described as a difference between:
an issuer credit rating and an issue credit rating.
a company credit rating and an industry average credit rating.
an investment grade credit rating and a noninvestment grade credit rating.
Notching refers to the credit rating agency practice of distinguishing between the credit rating of an issuer (generally for its senior unsecured debt) and the credit rating of particular debt issues from that issuer, which may differ from the issuer rating because of provisions such as seniority. (LOS 47.d)
Which of the following statements is least likely a limitation of relying on ratings from credit rating agencies?
Credit ratings are dynamic.
Firm-specific risks are difficult to rate.
Credit ratings adjust quickly to changes in bond prices.
Bond prices and credit spreads change much faster than credit ratings. (LOS 47.e)
Ratio analysis is most likely used to assess a borrower’s:
capacity.
character.
collateral.
Ratio analysis is used to assess a corporate borrower’s capacity to repay its debt obligations on time. (LOS 47.f)
Higher credit risk is indicated by a higher:
FFO/debt ratio.
debt/EBITDA ratio.
EBITDA/interest expense ratio.
A higher debt/EBITDA ratio is sign of higher leverage and higher credit risk. Higher FFO/debt and EBITDA/interest expense ratios indicate lower credit risk. (LOS 47.g, 47.h)
Compared to other firms in the same industry, an issuer with a credit rating of AAA should have a lower:
FFO/debt ratio.
operating margin.
debt/capital ratio.
A low debt/capital ratio is an indicator of low leverage. An issuer rated AAA is likely to have a high operating margin and a high FFO/debt ratio compared to its industry group. (LOS 47.g, 47.h)
Credit spreads tend to widen as:
the credit cycle improves.
economic conditions worsen.
broker-dealers become more willing to provide capital.
Credit spreads widen as economic conditions worsen. Spreads narrow as the credit cycle improves and as broker-dealers provide more capital to bond markets. (LOS 47.i)
Compared to shorter duration bonds, longer duration bonds:
have smaller bid-ask spreads.
are less sensitive to credit spreads.
have less certainty regarding future creditworthiness.
Longer duration bonds usually have longer maturities and carry more uncertainty of future creditworthiness. (LOS 47.i)
One key difference between sovereign bonds and municipal bonds is that sovereign issuers:
can print money.
have governmental taxing power.
are affected by economic conditions.
Sovereign entities can print money to repay debt, while municipal borrowers cannot. Both sovereign and municipal entities have taxing powers, and both are affected by economic conditions. (LOS 47.j)
