62. Credit Risk

What are some examples of risk that are difficult to anticipate and capture in credit ratings?

1. Litigation risk 2. Environmental risk 3. Natural disasters 4. Leveraged transactions

What are the 3 main credit rating agencies?

1. Moody's 2. S&P 3. Fitch

For a sovereign entity, what are its secondary sources of cash flow generation?

1. Newly issued debt 2. Sale of public assets, privatization

What is the main source of repayment for secured corporate bonds?

1. Operating cash flows 2. Collateral cash flows or sale

What main pitfalls occur from sole reliance on credit ratings in making investment decisions?

1. Potential for rating agency decisions to lag market pricing of credit risk 2. Overlook relevant financial risks 3. Involve miscalculations or unforeseen changes not fully captured in a rating agency's forward-looking analysis.

What are the two main components of credit risk (approximately expected loss)?

1. Probability of default 2. Loss given default

What are the two components of expected loss?

1. Probability of default (POD) 2. Loss given default (LGD)

The probability of default is determined based on what 3 factors?

1. Profitability: stable, predictable cash flows and profits 2. Coverage: sufficient cash flows/profits to make debt payments 3. Leverage: relative reliance on debt financing

What are some pitfalls of relying solely on credit agencies?

1. Rating agency decisions may lag market pricing of credit risk 2. They overlook key financial risks 3. May involve miscalculations or unforeseen changes not fully captured in a rating agency's forward-looking analysis.

For a sovereign entity, what are its primary sources of repayment?

1. Taxes 2. Tariffs, fees, and other government revenue

Credit spread changes affect holding period returns via two primary factors. What are they?

1. The basis point spread change. 2. The sensitivity of price to yield as reflected by end-of-period modified duration and convexity.

What is an illiquid borrower?

An illiquid borrower is one who lacks the resources to meet debt obligations as they come due. They are unable to raise the necessary funds to fulfill a debt obligation. They may not be able to tap credit lines, sell assets, or raise funding to make a timely debt payment.

What are investment grade bonds?

Bonds rated Baa3/BBB- or higher.

What is character?

Character refers to the quality of management and the willingness to repay indebtedness.

How is a rating issued?

The rating agencies often meet with the issuer and in some cases receive access to material non-public information, such as financial projections unavailable to public investors. They monitor the performance of debt issuers once a rating is issued, adjusting ratings higher as credit risk decreases or lower if default is deemed more likely. Credit agencies may issue a positive or negative outlook as creditworthiness improves or deteriorates but a rating change is not yet warranted.

What is credit migration (downside) risk?

The risk that a bond issuer's creditworthiness deteriorates, or migrates lower, leading investors to believe the risk of default is higher. Also called downgrade risk.

What is credit risk ?

The risk that an issuer does not make promised interest and principal repayments.

What is expected exposure?

The size of the investor's claim at the time of default

What is credit risk ?

the expected economic loss under a potential borrower default over the life of the contract

A $500,000 loan has the following characteristics: - Probability of default --> 5% - Collateral --> $100,000 - Recovery rate --> 90% Expected Exposure --> $400,000 The expected loss for this loan in the event of default is:

$1,500 EL = POD x (EE - Collateral) x (1 - RR) EL = .05 x (400,000 - 100,000) x (1 - .90)

What are three chief sources of credit risk?

1. Adverse macroeconomic conditions 2. A financing mismatch between resources and obligations 3. Issuer specific factors in corporate and sovereign debt markets

For a corporate borrower, what are its secondary sources of cash flow generation?

1. Asset sales 2. Divestitures 3. Additional debt issuance 4. Equity issuance

For a corporate borrower, what are its primary sources of cash flow generation?

1. Business operations 2. Investing and financing activities

What are the five bottom-up credit criteria?

1. Capital 2. Character 3. Covenant 4. Collateral 5. Capacity

What are the eight Cs of credit analysis that are used to evaluate creditworthiness?

1. Country 2. Conditions 3. Currency 4. Capacity 5. Capital 6. Character 7. Covenants 8. Collateral

What are the three examples of top-down credit factors?

1. Currency 2. Condition 3. Country

For a sovereign entity, what are its sources of credit risk?

1. Economic contraction 2. Political uncertainty 3. Excessive debt service needs 4. Expansionary economic policies 5. Budget deficits 6. Tax cuts 7. Limited ability to collect taxes

For a corporate borrower, what are its sources of credit risk?

1. Economic contraction 2. Strategic shifts in the business and market environment 3. Increased competition 4. Reduced pricing power 5. Shrinking operating margins 6. Excessive debt service needs

How does an investor react in the presence of credit risk?

A fixed-income investor seeks compensation for the expected economic loss under a potential borrower default.

A forward-looking analysis may overlook or understate what?

A forward-looking analysis may overlook or understate key financial risks.

Credit ratings are: a. developed on behalf of investors. b. a symbol-based measure of the potential default risk of a bond issue or issuer. c. measures of credit risk that are used to determine bond market pricing.

A symbol-based measure of the potential default risk of a bond issue or issuer.

What is the main reason for a borrower's inability to make timely payments?

Although this may be due to several underlying and contributing factors, it ultimately results from a lack of sufficient cash flow available to make current debt payment.

How does an illiquid borrower differ from an insolvent borrower?

An insolvent borrower is a borrower whose assets are worth less than its liabilities.

Which of the following statements best describes the difference between unsecured and secured debt obligations in the event of issuer default? a. Unsecured debtholders only have access to issuer cash flows, while secured debtholders only have access to specific pledged assets. b. Both unsecured and secured debtholders have access to unpledged assets, while only secured debtholders have access to specific pledged assets as a secondary repayment source. c. Only unsecured debtholders have access to pledged assets, while only secured debtholders have access to specific pledged assets.

B. Both unsecured and secured debtholders have access to unpledged assets, while only secured debtholders have access to specific pledged assets as a secondary repayment source.

Which of the following choices properly ranks ratings from the three major credit rating agencies from the lowest to highest credit risk? a. B1, Ba2, Baa3 b. BBB+, Ba3, B- c. Baa1, BB, Baa3

BBB+, Ba3, B-

What are high yield bonds?

Bonds rated Ba1 or lower by Moody's and BB+ or lower by S&P and Fitch.

What is capacity?

Capacity refers to the ability of the borrower to make its debt payments on time.

Changes in profitability, coverage, and leverage ratios result in what?

Changes in these result in credit rating upgrades or downgrades as well as changing credit spreads.

Capacity and capital are quantitative metrics based on financial statements. The other three are what kind of measures?

Character, covenants, and collateral are qualitative measures that analysts assess based on historical company performance, credit relationships and the reputation of current management.

What is collateral?

Collateral refers to the quality and value of the assets supporting the issuer's indebtedness.

What is one way to interpret the expected loss on a fixed-income security for a given period?

Compare it to the compensation for an investor expects for taking on the credit risk of a borrower over that period. The G-spread is roughly approximate to the expected loss. The investor is thus fairly compensated if the expected loss is equal to the credit spread. They are more than fairly compensated if the credit spread exceeds their expected loss.

What are split ratings?

Complex risks viewed very differently by rating agencies

What are conditions?

Conditions refer to the general economic, competitive, and business environment faced by all borrowers that may affect their ability to service or refinance debt.

What is country?

Country involves the geopolitical environment as well as the legal and political system faced by all issuers in a jurisdiction that may affect debt payment.

What are convenants?

Covenants are legal terms of debt agreements that an issuer must comply with.

How is coverage measured? A higher (lower) coverage has what effect on credit quality?

Coverage is measured as EBIT/interest expense. Higher (lower) coverage is associated with lower (higher) credit quality.

Credit ratings seek to assess what, while pricing for distressed debt is focused on what?

Credit ratings seek to assess expected loss, whereas for distressed debt, pricing is more focused on default timing and expected recovery rates.

Credit risk depends on what?

Credit risk depends on specific factors related to the borrower itself as well as general economic conditions and is subject to change over the life of the contract.

What is credit risk?

Credit risk is the risk of economic loss resulting from borrower failure to make fully and timely payments of interest and principal.

What is currency?

Currency affects issuers whose cash flows are affected by exchange rate changes or who borrow in a currency outside of their jurisdiction, such as sovereign issuers with foreign currency debt.

What is unsecured debt?

Debt without collateral, in which the primary source of repayment is the cash generated by the business.

What is expected loss (EL)?

Default probability times loss severity given default.

Credit Rating Agencies & Credit Ratings

Disregard

Introduction

Disregard

Sources of Credit Risk

Disregard

What is the expected loss formula?

Expected Loss = POD x [EE x ( 1 - RR)]

Expected exposure is calculated how?

Expected exposure is the amount an investor may expect to lose in the case of default, which is usually equal to the loan or bond face value plus accrued interest less the current market value of available collateral.

Credit risk is: a. activated upon a borrower's default. b. the spread an investor receives above the risk-free rate. c. experienced in several ways by lenders.

Experienced in several ways by lenders. They include: 1. Failure to receive principal and interest payments. 2. Inability to sell collateral at a market price sufficient to meet an issuer's obligations in the case of secured debt. 3. The potential incurrence of legal or other costs to collect debt.

Five of these criteria relate to what?

Five of these criteria related to specific bottom-up factors. Bottom-up factors are applicable to the individual borrower itself.

What are high-yield bonds?

High-yield bonds are those rated BB+ or lower by S&P/Fitch or Ba1 or lower by Moody's. They represent substantial to very high credit risk.

Which of the following factors are associated with a lower probability of default and higher credit quality for a corporate issuer? a. Higher profitability, higher coverage, and higher leverage b. Higher profitability, lower coverage, and lower leverage c. Higher profitability, higher coverage, and lower leverage

Higher profitability, higher coverage, and lower leverage

What happens if a secured borrower is in default?

If the firm fails to make timely payments, the note is in default. This sends all debt into default due to the pari passu and cross-default clause. While all debt investors have access to any unpledged assets, specific pledged assets serve as a secondary source of repayment for specific debt.

Determine the correct answers to fill in the blanks: In comparison to high-yield bonds, investment-grade bonds have a __________ risk profile and are __________ negatively affected by adverse economic and market conditions.

In comparison to high-yield bonds, investment-grade bonds have a LOWER risk profile and are LESS negatively affected by adverse economic and market conditions.

What are investment grade issuers?

Investment-grade issues pose the lowest risk of default and are rated Baa3 by Moody's and BBB- or higher by S&P and Fitch.

What kind of risk do fixed-income investors face?

Investors face credit risk, a form of performance risk in a contractual relationship.

What benefit does issuers of bonds rated investment grade?

Issuers of bonds rated investment grade are more consistently able to issue debt and can borrow at lower interest rates than those rated below investment grade. They also have a lower risk profile, are less negatively affected by adverse economic conditions, and are more appropriate for institutional portfolios.

For investors in unsecured investment-grade bonds or loans with high LGD, where does the greatest risk of expected loss arise from?

It arises from a rise in POD

The loss given default combines what two things?

It combines the severity of loss under a default scenario with the amount of the investor's claim at the time of default.

The LGD can be expressed in what two ways?

LGD can be expressed either in currency terms or as a percentage of principal. The latter form is more useful in analysis because it allows comparison between borrowers and investments of different sizes.

How are lenders affected by credit risk?

Lenders are affected by credit risk because they may lose their principal and interest due, which can impact their own ability to repay debt. Payment delays as well as increased legal and collection costs may further reduce their income and margins.

What are credit ratings?

Letter-grade, qualitative measures of an issuer's ability to meet its debt obligations based on both the probability of default and the expected loss under a default scenario. They are used to satisfy regulatory, statutory, and contractual requirements.

How is leverage measured? A higher (lower) amount of leverage has what effect on credit quality?

Leverage is measured either as debt to EBITDA or cash flow to net debt. Lower (higher) leverage is associated with higher (lower) POD and lower (higher) credit quality.

What is LGD a function of?

Loss given default is largely a function of the nature and seniority of a creditors claim in a default situation.

When will noteholders in this type of debt begin to suffer a credit loss?

Only when the value of the pledged assets fall below the total amount of pari passu secured debt.

What is the main source of repayment for unsecured corporate bonds?

Operating cash flows

What is capital?

Other company resources available that reduce reliance on debt

How is profitability measured? Higher (lower) profitability has what effect on credit quality?

Profitability is measured by EBIT margin. Higher (lower) profitability is associated with lower (higher) POD and higher (lower) credit quality.

What do rating agencies do?

Rating agencies independently assess issuer credit risk on a forward-looking basis using quantitative and qualitative analysis.

Ratings are issued on behalf of who?

Ratings are issued on behalf of the issuer.

What is secured debt?

Secured debt is debt with collateral, in which the primary source of repayment remains the firm's cash flows, but is also supported by collateral pledged by the company.

Secured debt and higher seniority affects LGD how?

Secured debt with higher seniority is associated with a lower LGD.

What happens if an unsecured borrower is in default?

Since a firm's bonds are unsecured and unsubordinated obligations with pari-passu and cross-default language in its bond indenture, failure to repay unsecured indebtedness means that all its debt obligations are in default and investors must rely on BRWA's general asset pool to satisfy their obligations.

Determine the correct answers to fill in the blanks: Spreads are __________ at or near the top of the credit cycle, when market participants perceive credit risk to be at its lowest; they are __________ at or near the bottom of the credit cycle, when financial markets believe credit risk has reached its peak.

Spreads are tightest at or near the top of the credit cycle, when market participants perceive credit risk to be at its lowest; they are widest at or near the bottom of the credit cycle, when financial markets believe credit risk has reached its peak.

What is the main source of repayment for sovereign bonds?

Tax Revenues

What is the D rating?

The D rating is reserved for securities that are already in default.

What is loss given default (LGD)?

The investor's loss conditional on an issuer event of default.

What is probability of default (POD)?

The likelihood that an issuer fails to make full and timely payments of principal and interest; typically an annualized measure.

What is the recovery rate (RR)?

The percentage of an outstanding debt claim recovered when an issuer defaults

What is loss severity?

The unrecovered portion of the claim.

When does the yield spread widen?

The yield spread at which corporate bonds trade relative to default risk-free assets widen when credit risk rises.

When does the yield spread narrow?

The yield spread narrows if credit risk falls.

What are top-down factors?

These factors apply to all borrowers to a greater or lesser extent.

How do HY investors try to minimize EL?

They try to minimize EL by seeking covenant restrictions and/or security to lower LGD.

What are bonds rated triple-A?

Triple A bonds are of the highest quality and are subject to the lowest level of credit risk.

T/F - the probability of default typically is an annualized measure?

True

Unsecured debt and lower seniority affects LGD how?

Unsecured debt and lower seniority are associated with a higher LGD.

What is default?

When a borrower on a mortgage loan fails to meet the obligations of the loan.

What is the relationship between the likelihood of default and the actual loss for both IG and HY borrowers?

While the likelihood of default for investment-grade borrowers is well below that of a high-yield issuer, the investor's loss in the event of default for secured debt is lower than unsecured debt due to the secondary source of repayment for secured bonds.

A portfolio manager assessing a downside case believes that HY bond spreads will rise 100 bps in a recession. If an observed HY bond has modified duration of 4.5 and reported convexity of 0.23, the expected change in the HY bond's price under this scenario would be closest to: a. -4.5%. b. -4.385%. c. -4.615%.

b. -4.385% change in price = -(4.5 x .01) + (1/2)(23)(.01)^2

Which of the following statements best describes risks that are difficult to capture in credit ratings? a. Environmental risks are captured by ESG ratings rather than credit ratings. b. Debt-financed acquisitions are usually captured in credit ratings. c. Split ratings demonstrate that credit rating agencies may view complex risks very differently.

c. Split ratings demonstrate that credit rating agencies may view complex risks very differently.