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CREDIT RISK AND BOND RATINGS - Coggle Diagram
CREDIT RISK AND BOND RATINGS
Credit risk
Credit risk: potential losses from the failure of a borrower to make promised payments
Default risk: the probability that a borrower will fail to pay interest or principal when due
Loss severity: the value that a bond investor will lose if the issuer defaults.
Expected loss: the default risk multiplied by the loss severity
Recovery rate: the percentage of a bond’s value an investor will receive if the issuer defaults
Yield spread: The difference in yield between a credit-risky bond and a credit-risk-free bond of similar maturity
Spread risk: the possibility that a bond’s spread will widen due to one or both of these factors
Market liquidity risk: the risk of receiving less than market value when selling bonds and is relected in their bid-ask spreads
Downgrade risk: the risk that spreads will increase because the issuer has become less creditworthy so its credit rating is lowered.
Seniority ranking: the priority of a bond’s claim to the issuer’s assets and cash flows
First lien/senior secured > Second lien/secured > Senior unsecured > Senior subordinated>Subordinated > Junior subordinated
Credit Ratings
corporate family ratings: issuer credit ratings
corporate credit ratings: issue-speciic ratings
investment grade: Baa3/BBB– or higher
junk bonds:Ba1/BB+ or lower
Notching: practice of assigning different ratings to bonds of the same issuer.
parent company’s bonds subordinated to the subsidiary’s bonds
Credit Analysis
Collateral
More important for less creditworthy companies
Covenants
Affirmative covenants: require the borrower to take certain actions, and are typically for administrative purposes
Negative covenants: restrict the borrower from taking certain actions that may reduce the value of the bondholders’ claims
Capacity
Industry fundamentals
Industry cyclicality
Growth prospects
Company fundamentals
Competitive position
Operating history
Management’s strategy and execution
Leverage and coverage ratios
Industry structure
Rivalry among existing competitors
Threat of new entrants
Threat of substitute products
Bargaining power of buyers
Bargaining power of supplier
Character
Management’s ability to develop a sound strategy
Management’s past performance in operating the company without bankruptcies or restructurings
Accounting policies and tax strategies that may be hiding problems
Record of fraud or other legal and regulatory problems
Prior treatment of bondholders