Sponsor covenant (1)
Credit assessment techniques

business outlook

financial metrics

implied market default risk

credit rating

Merton-type credit risk models

quantitatively derived credit risk

independent business review

assessment of the business outlook in general and of the sponsor's specific sector

pros

cheap to obtain

cons

subjective

difficult to quantify

Financial statistics and accounting rations, such as interest cover and gearing/ leverage can be compared both

with similar companies

with previous years to spot any trends, particularly deterioration

example

PPF use sponsor covenant ratings based on financial metrics to estimate the likelihood of short-term insolvency.

pros :

simple

cheap

cons

does not give an indication of the absolute level of risk

access to management accounts required (not publicly available)

where a sponsor has issued investments such as equities or bonds, the market prices of these investments can indicate how the market views the sponsor's credit risks and how these change over time.

market prices also determined by liquidity risk, supply and demand and risk appetite of investors

only larger companies tend to have full credit ratings

coverage wider than for implied market default risk method

limited use

where a sponsor has traded equities, a model can be used to determine the probability of default based on the behaviour of the equities.

Quantifiable

not widely available

costly

bonds

excess of the yield over gov bonds

equities

mathematical models used to determine the relationship between a company's equity and debt to derive a cost of default

Merton model

Treats the value of a traded equity as the excess value of its business less its debt

Black-scholes model

Models credit quality as a function of the relative amounts of equity and debt and the volatility of the underlying business

model deriving a credit rating or probability of default from standard corporate accounting data, augmented by confidential credit information from credit bureaux and/or commercial banks.

wide usage

relies on accounting information updated annually in arrears

up-to-date info not easily available

report by external credit advisory specialist

typically an accounting form, insolvency practitioner or other specialist

cons

expensive

pros

take explicit account of the interdependence of funding and sponsor convenant

help trustees determine how much the sponsor can afford.

Risk to a pension scheme will differ from implied market default risk due to a number of factors including differences in priority and/ or security provided

companies pay specialist agency to provide them with credit rating

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