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Chapter 5: Fundamental of credit analysis (Rating agencies (reasons of…
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
Seniority ranking
priority of payment when the issuer is insolvent
absolute priority
: senior creditors are paid in full before junior creditors
rating agencies, credit rating and their roles
level of seniority ranking (exhibit 1 - page 215)
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
Recovery rates
vary due to
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
Traditional credit analysis: corporate debt securities
4C analysis
Collateral
Covenants
Capacity
Character
Rating agencies
symbol- based ratings
: an assessment of a bond issue's risk of default
reasons of popular
Easy of comparison across issuers and market segments
Even regulatory and statutory rely on the ratings
Independent assessment of credit risk
Issuers pay for the service
Hugh growth of debt markets
Bond portfolio management depends on the ratings
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
rating matrix
investment vs non- investment grade
positive, stable or negative