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Credit spread risk: This is the risk that the yield spread on a fixed-income security over some benchmark yield (such as a comparable Treasury security) will widen due to a change in the return the market demands for taking credit risk.
Downgrade risk: This is the risk that the price of a fixed-income security may fall because its credit rating is downgraded by one or more of the credit-rating agencies
Market liquidity risk: Selling a bond less than its market value and is reflected in the size of the bid-ask spread. This risk is greater for bonds with less creditworthy issuers and for bonds of smaller issuers with relatively little publicly traded debt.
Credit Risk
Fundamentals of Credit Analysis
August 2014 © Dr. Enzo Mondello, CFA, FRM, CAIA
Each category of debt from the same issuer is ranked in accordance to a priority of claims in the event of default
Secured debt is backed by a collateral
Unsecured debt or debentures reflect a general claim to the issuer’s assets and cash flows General seniority rankings for debt repayment priority are:
– First lien or first mortgage (specific asset is pledged) – Senior secured debt
– Junior secured debt – Senior unsecured debt – Senior subordinated debt – Subordinated debt
– Junior subordinated debt
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All debt with the same category is ranked as pari passu (same priority of claim)
A bankruptcy reorganization plan is confirmed by a vote among all classes of investors with less than 100% recovery rate. Typically a reorganization plan does not strictly conform to the original priority of claims.
Credit Risk
Fundamentals of Credit Analysis
August 2014 © Dr. Enzo Mondello, CFA, FRM, CAIA
Issuer credit ratings, or corporate family ratings, represent a debt issuer’s overall creditworthiness and typically apply to a company’s senior unsecured debt
Issue-specific ratings, or corporate credit ratings, represent the credit risk of a specific debt issue
Cross default provision: default in one of the outstanding bonds may trigger default on the remaining issues
Notching refers to the practice of adjusting an issue credit rating upward or downward from the issuer credit rating to reflect the seniority and other provisions of a debt issue. Notching is less common for highly rated issues than for lower-rated issues. For lower-rated issues, higher default risk results in significant differences between recovery rates of debt with different seniority rankings, leading to more notching.
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Fundamentals of Credit Analysis
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Lenders and bond investors should not rely exclusively on credit ratings from rating agencies for the following reasons: – Credit ratings are dynamic and can change during the life of a debt issue
– Rating agencies are not perfect and cannot always judge credit risk accurately – Event risk is difficult to asses: unforeseen events are not reflected in credit ratings – Market prices of bonds often adjust more rapidly than credit ratings
Credit Risk
Fundamentals of Credit Analysis
August 2014 © Dr. Enzo Mondello, CFA, FRM, CAIA
In ve st men t G rad e
Moody’s S&P Fitch
Aaa AAA AAA
High-Quality Aa1 AA+ AA+ Grade Aa2 AA AA Aa3 AA AA A1 A+ A+ Upper-Medium A2 A A Grade A3 A A Baa1 BBB+ BBB+
Low Medium Baa2 BBB BBB Grade Baa3 BBB BBB
____________________________________________________________________________________
Ba1 BB+ BB+
Low Grade or Ba2 BB BB Speculative Grade .... .... ... C C C ____________________________________________________________________________________ Default C D D Non -In ve st men t Grad e “Jun ”“ or “ High Y ie ld ”
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Fundamentals of Credit Analysis
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Components of Traditional Credit Analysis
In traditional credit analysis, the following four C’s of credit are considered: capacity, collateral, covenants, and character
Character: Management’s ability to manage potential crises is a key factor in assessing a borrower’s character. Management should have demonstrated their ability to define and execute a strategic plan. The track record
can be used to measure the character of the management.
Assessing the quality of the management by the rating agencies include: – Understanding of business strategies and policies
– Financial philosophy and strategic direction – Conservative approach to business
– Track record
– Succession planning (continuity of management) – Well-developed business plans
– Well-developed control systems
Credit Risk
Fundamentals of Credit Analysis
August 2014 © Dr. Enzo Mondello, CFA, FRM, CAIA
Capacity to repay: A firm will receive the funds to service its debt (interest and principal payments) from its cash flow. Sales less operating expenses must be enough to cover interest charges. An analyst can calculate the capacity to repay the debt burden by the use of ratios and cash flows derived from the financial statements.
Analysis of collateral (underlying capital): A corporate debt obligation can be secured or unsecured. In a
liquidation, the proceeds from bankruptcy are distributed to creditors based on the absolute priority rule (risk of loss is reduced for secured debt). However, in the case of a reorganization the absolute priority rule does typically not hold. A secured creditor may receive only a portion of its claim, while unsecured creditors may receive distributions for their entire claim. This is the case because a reorganization requires approval of all parties. – As a consequence, analysts place less emphasis on the collateral.
Issue covenants: Covenants include limitations and restrictions on the borrower’s activities
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The bond indenture should contain terms and conditions that are appropriate to ensure payment of the debt. Covenants are usually imposed by the bondholders to restrict companies from taking action that might not be in the
bondholders’ best interest.
There are two general types of covenants:
– Affirmative covenants (the debtor promises to take action)
– Negative covenants (the debtor promises not to do certain things)
Examples of affirmative covenants are to make interest and principal payments and to keep the equipment in good working order
Examples of negative covenants are not to incur additional debt and not to exceed limits on solvency, capitalization, or coverage ratios
Credit Risk
Fundamentals of Credit Analysis
August 2014 © Dr. Enzo Mondello, CFA, FRM, CAIA
Sources of liquidity are:
Liquid assets are needed to pay debt obligations as they come due
The primary source is cash flow which is derived from net sales less operating costs
Additional sources of liquidity come from the firm’s ability to obtain additional financing to meet immediate needs. These additional sources include:
– A line of bank credit
– Securitization of loans or receivables – Third party guarantees
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Fundamentals of Credit Analysis
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Factors that Influence the Level and Volatility of Yield Spreads
Yield of option-free bond = Real risk-free rate + Expected inflation rate + Maturity premium + Liquidity premium + Credit Spread
Yield spread = Liquidity premium + Credit Spread
The level and volatility of yield spreads are affected by: – Credit and business cycles
– Performance of financial markets as a whole – Availability of capital from broker-dealers, and – Supply and demand for debt issues
Credit Risk
Fundamentals of Credit Analysis
August 2014 © Dr. Enzo Mondello, CFA, FRM, CAIA
Yield spreads tend to narrow when:
– Credit cycle is improving – Economy is expanding
– Financial markets are strong, and/or
– Investor demand for new debt issues is strong
On the other hand, yield spreads tend to widen when: – Credit cycle is weakening,
– Economy is weakening,
– Financial markets are weakening,
– Broker-dealer capital is insufficient for market making, and/or – Supply of new debt issues is heavy
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Example:
Which bonds are likely to exhibit the greatest spread volatility? A. Bonds from issuers rated AA
B. Bonds from issuers rated B C. Bonds from issuers rated A
Example:
If investors become increasingly worried about the economy – say, as shown by declining stock prices- what is the most likely impact on credit spreads?
A. No change to credit spreads because they are not affected by equity markets
B. Narrower spreads will occur because investors will move out of equities into debt securities C. Wider spreads will occur because investors are concerned about weaker creditworthiness
Credit Risk
Fundamentals of Credit Analysis
August 2014 © Dr. Enzo Mondello, CFA, FRM, CAIA
Return Impact of Spread Changes
Small spread changes:
Return impact ( Modified Duration) x ( Spread) Larger spread changes:
Return impact ( Modified Duration) x ( Spread) + 0.5 x (Convexity) x ( Spread)^2
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Fundamentals of Credit Analysis
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Longer maturity bonds have higher duration and as a consequence higher spread sensitivity. Longer maturity bonds have higher credit spreads. Longer maturity bonds also tend to have larger bid-ask spreads (i.e., higher transaction costs), implying investors in longer maturity bonds would require higher spreads.
Credit curves are typically upward sloping
Active bond managers have to forecast spread changes and expected credit losses for individual bonds and for the overall bond portfolio in order to improve portfolio performance
Credit Risk
Fundamentals of Credit Analysis
August 2014 © Dr. Enzo Mondello, CFA, FRM, CAIA
Yield = Benchmark Yield + Risk Premium (Spread) where:
Benchmark yield = risk-free rate = expected inflation rate + expected real rate Risk premium = credit risk + liquidity risk + taxation
Estimated price change in % = –Duration ( spread) + 0.5 Convexity ( spread)2
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Example
The flat price on a fixed-rate corporate bond falls one day from 92.25 to 91.25 per 100 of par value because of poor earnings and an unexpected ratings downgrade of the issuer. The (annual) modified duration for the bond is 7.24. Which of the following is closest to the estimated change in the credit spread on the corporate bond, assuming benchmark yields are unchanged?
A. 15 bps. B. 100 bps. C. 129 bps.
Credit Risk
Fundamentals of Credit Analysis
August 2014 © Dr. Enzo Mondello, CFA, FRM, CAIA
High Yield Bonds
High yield bonds are more likely to default than investment grade bonds, which increases the importance of estimating loss severity. Analysis of high yield debt should focus on:
– Liquidity
– Projected financial performance
– The issuer’s corporate and debt structures – Debt covenants
A credit analyst will need to calculate leverage for each level of the debt structure when an issuer has multiple layers of debt with a variety of expected recovery rates
High yield issuers for whom secured bank debt is a high proportion of the capital structure are so called top heavy
and have less capacity for additional bank borrowings in financially stressful period
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Fundamentals of Credit Analysis
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Issuers of high-yield bonds typically have a holding company structure. The assets and cash flows that are available to pay the debt service will reside in operating subsidiaries.
A financial analysis of every subsidiary may be necessary in order to determine if the individual subsidiaries will be able to generate sufficient excess cash flow to pay to the parent so that the parent can meet its debt service
requirements
High-yield issuers are risky in the first place. It is, therefore, very important to analyze the covenants in their indentures to determine whether or not they are sufficiently limiting so as to “force” the company to preserve cash and assets as collateral.
Credit Risk
Fundamentals of Credit Analysis
August 2014 © Dr. Enzo Mondello, CFA, FRM, CAIA
Important covenants for high yield debt include:
– Change of control put: debt holders have the right to require the issuer to buy back debt (at or above par) in the event of an acquisition
– Restricted payments: amount of cash that may be paid to equity holders is limited – Limitations on liens: amount of secured debt that a borrower can carry is limited
– Restricted versus unrestricted subsidiaries: restricted subsidiaries’ cash flows and assets can be used to service the debt of the parent holding company
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Fundamentals of Credit Analysis
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High-yield debt is not as risky as equity investments, but it is more risky than investment quality bonds. –
The empirical evidence is that the returns on high-yield debt are more closely correlated with the returns on equities than the returns on bonds.
The best way to analyze high-yield bonds is to perform the same type of long-term cash flow projection that is used to analyze the value of equity because these bonds tend to have below average solvency and interest coverage ratios and above average debt-to-capital ratios
For example, analysts can compare companies based on the difference between their EV/EBITDA and Debt/EBITDA ratios. Companies with a wider difference between these two ratios have greater equity relative to their debt and therefore have less credit risk.
Credit Risk
Fundamentals of Credit Analysis
August 2014 © Dr. Enzo Mondello, CFA, FRM, CAIA
Sovereign Bonds
Sovereign debt is the debt of foreign governments. This kind of debt is unique insofar as it is necessary to analyze both
– A sovereign government’s ability to pay its debt
– And its willingness to pay its debts. Rating agencies consider the following factors: – Political risk
– Income and economic structure – Economic growth prospects – Fiscal flexibility
– Public debt burden – Price stability (inflation) – Balance of payment flexibility – External debt and liquidity
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S&P assigns two ratings:
– Local currency denominated debt rating
– Foreign currency denominated debt rating
Historically the risk of defaults has been greater on debts not denominated in the issuer’s local currency. While a country can levy taxes (or print money) to repay its local currency debts, it must generate real economic activity to repay debts in another currency.
Sovereign defaults can be caused by events such as war, political instability, severe devaluation of the currency, or large declines in the prices of the country’s export commodities. Access to debt markets can be difficult in bad economic times.
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Fundamentals of Credit Analysis
August 2014 © Dr. Enzo Mondello, CFA, FRM, CAIA 135
Risks Associated with Investing in Bonds
Fixed-Income Valuation
Term Structure of Interest Rates
Yield Measures
Interest Rate Risk: Duration and Convexity
Credit Risk: Fundamentals of Credit Analysis
Managing Bond Portfolio
Content
Relative-Value Methodologies for Global
Corporate Bond Portfolio Management
Exchange Rate Risk: International Bond Investing
Managing Interest Rate Risk with Derivatives
Managing Credit Risk with Derivatives
Currency Risk Management
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Introduction
Set investment objectives
– It depends upon the institution and is typically expressed in terms of return and risk
Establish investment policy
– It begins with asset allocation. Client and regulatory constraints in addition to tax and financial reporting implications must be considered