Chapter 5: Fundamental of credit analysis

Introduction

credit analysis: efficiently allocating capital by properly assessing credit risk, pricing it accordingly, and repricing it as risks change

credit risk: risk of loss resulting from borrower failing to make full and timely payments of interest and/or principle

default risk: the probability that a borrower defaults

loss severity: in the event of default, the portion of a bond's value (including unpaid interest) an investor losses

expected loss: measure of credit risk

E = Default probability x loss (severity) given default (LGD)

LGD = 1 - Recovery rate

Recovery rate: percentage of percentage of the principle amount recovered in the default event

Spread risk

widen of yield spreads due to

deterioration of issuer's creditworthiness (downgrade risk)

an increase in market liquidity risk : price at which investors can actually transact may differ from the price indicated in the market

Capital structure, seniority ranking, and recovery rates

  1. Seniority ranking

priority of payment when the issuer is insolvent

  1. Capital structure

debt and equity proportion of a firm that could generate CFs from the firm's operation

regular capital structure: bank loans, bonds of different seniority, preferred stock, and common equity

debt

unsecured: only has a general claim on an issuer's assets and CFs

secured: debt- holder has a direct claim on certain assets and their CFs

  1. Recovery rates

vary due to

absolute priority : senior creditors are paid in full before junior creditors

rating agencies, credit rating and their roles

Traditional credit analysis: corporate debt securities

4C analysis

Collateral

Covenants

Capacity

Character

level of seniority ranking (exhibit 1 - page 215)

seniority of ranking

industry

credit cycle: expansion and contraction of access to credit (borrowing form banks) overtime

economic cycle: recovery rates are lower when economy is in recession

Rating agencies

symbol- based ratings: an assessment of a bond issue's risk of default

reasons of popular

two types

issue ratings: seniority ranking (refer to specific financial obligations of an issuer - ranking in the capital structure)

issuer credit ratings: overall creditworthiness (usually apply to its senior unsecured debt)

notching process: credit ratings on issues can be moved up or down from the issuer rating
For example: subordinated debt can be rated up to two notes below a non- investment grade corporate credit rating, but one notch at most if the corporate credit rating is investment grade

limitations

credit ratings can change overtime

credit ratings tend to lag the market's pricing of credit risk: credit ratings are behind the market's assessment of issuer's creditworthiness (bond prices change more frequently)

rating agencies may make give ratings based on fraud information

some risks are difficult to capture in credit ratings

  1. Easy of comparison across issuers and market segments
  1. Even regulatory and statutory rely on the ratings
  1. Independent assessment of credit risk
  1. Issuers pay for the service
  1. Hugh growth of debt markets
  1. Bond portfolio management depends on the ratings

rating matrix

investment vs non- investment grade

positive, stable or negative