R 62 Credit Risk

Focus of the Reading

o Describe credit risk and its components,
probability of default and loss given default.
o Describe the uses of ratings from credit rating
agencies and their limitations.
o Describe macroeconomic, market, and issuer-
specific factors that influence the level and
volatility of yield spreads.
Describe credit risk and its components, probability
of default and loss given default.

Credit risk is the risk associated with losses to fixed

income investors stemming from the failure of a
borrower to make payment of interest or principal
(referred to as to servicing their debt). When a
borrower fails to service their debt, they are said to be
in default.

The key drivers of credit risk are either specific to the

borrower (bottom up) or relate to general economic
conditions (top down). These are often referred to as
the Cs of credit analysis.
Bottom-up credit analysis factors are as follows:

Capacity. The borrowerÕs ability to make their debt

payments on [Link] resources available to the
borrower that reduce reliance on debt.

Collateral. The value of assets pledged to provide the

lender with security in the event of default.

Covenants. The legal terms and conditions the

borrowers and lenders agree to as part of a bond issue.

Character. The borrowerÕs integrity (e.g., management

for a corporate bond) and their commitment to make
payments under their debt obligations.
Top-down credit analysis factors are as follows:
Conditions. The general economic environment that
affects all borrowersÕ ability to make payments on their
debt.

Country. The geopolitical environment, legal system, and

political system that apply to the debt.

Currency. Foreign exchange fluctuations and their

impact on a borrowerÕs ability to service foreign-
denominated debt.

At its core, credit risk stems from the possibility that

the borrowerÕs sources of repayments will not provide
enough cash to service their debt.
The sources of repayment for a debt issuer depend on
the nature of the borrower and the specifics of the loan
or bond issue.

Secured corporate debt is backed primarily by the

operating cash flows and investments of the business
plus cash flows generated from collateral specifically
pledged as security for the debt.

Unsecured corporate debt is only backed by the

operating cash flows and investments of the issuer (as
well as secondary sources of cash flow such as asset
sales, divestures of subsidiaries, or additional
debt/equity issuance). Credit risk for a corporate issuer
may come from poor economic and market conditions,
increased competition, low profitability, or having
excessive debt levels.
Sovereign debt is backed by tax revenue, tariffs, and
other fees charged by the government issuer.
Secondary sources of cash flow include additional debt
issuance and sale of public assets (privatizations). Credit
risk for a sovereign issuer may stem from poor economic
conditions and political uncertainty, fiscal deficits (tax
revenue being less than government spending), and high
debt levels relative to the size of the economy.

Credit analysts should distinguish between an issuer

being illiquid, or unable to raise cash to service debt,
and being insolvent, where the assets of an issuer fall
below the value of its debt. An illiquid issuer may not
necessarily be insolvent, but could still default.

When default occurs, clauses written into a bond

indenture are important. A cross default clause means
that a default on one bond issue causes a default on all
issues.
A pari passu clause means all bonds of a certain type
rank equally in the default process. When pari passu and
cross-default provisions exist on unsecured debt, a
default on one issue implies that all holders of
unsecured claims have access to the general assets of
the issuer to satisfy their obligations. For secured
debtholders, such clauses mean default on any obligation
of the issuer will grant access to the general assets of
the company and to the assets pledged as collateral for
the debt. Only when the value of the pledged assets
falls below the amount of pari passu secured debt will a
secured bond investor suffer credit losses.
Measuring Credit Risk
Credit risk is measured by assessing the expected loss
from a debt investment in the event of default:

expected loss = probability of default × loss given

default

Probability of default is the probability that a

borrower fails to pay interest or repay principal when
due. The probability is typically expressed on an
annualized basis. Loss given default is the loss an
investor will suffer if the issuer defaults. This can be
stated as a monetary amount or as a percentage.

A bondÕs expected recovery rate is the proportion of a

claim an investor will recover if the issuer defaults. The
proportion an investor will not recover, or one minus the
recovery rate, is known as loss severity.
A debt investorÕs expected exposure or exposure at
default is the difference between the amount the
investor is owed (principal and accrued interest) and the
value of the collateral available to repay the investor.
Loss given default, stated as a percentage, is the
product of the expected exposure and the loss severity:

LGD% = expected exposure × (1 - recovery rate)

We can use the annualized expected loss (as a

percentage) as an estimate of the annualized credit
spread over a risk-free benchmark that an investor
should demand for facing the credit risk of the
investment:

credit spread ≈ probability of default × LGD%

If the actual credit spread of the issue is higher than
this estimated credit spread, the investor is more than
fairly compensated for the credit risk of the
investment. If the actual credit spread of a bond is less
than this estimated credit spread, investors are not
adequately compensated for credit risk and should avoid
investing.
Example:

A bond issuer has a 3% probability of default, and one

of its bond issues has a recovery rate of 75%. The bond
has a 4% coupon and is currently trading at par. A
government security of similar maturity yields 2.5%.
Assess whether the credit spread of the bond issue is
adequately compensating investors for credit risk.
To assess the required returns from credit-risky bonds,
an analyst will need to estimate the probability of
default for the issuer and the loss given default for the
bond issue.

Probability of default can be assessed through

quantitative metrics relating to capacity to repay. For
example, a profitable company with high EBIT margin, a
high interest coverage ratio (EBIT/interest), low
leverage multiples (e.g., debt/EBITDA), and a high ratio
of cash flow to net debt would be deemed of high credit
quality (low probability of default).

Estimates of loss given default depend on the whether

the bond is secured or unsecured, and the level of
seniority of the bond issue in the capital structure of
the issuer. More senior, secured debt will have lower
losses given default than junior, unsecured debt.
Due to their financial strength, investment grade
issuers have lower probability of default than high-yield
issuers. However, high-yield issuers often issue secured
debt with a secondary source of repayment in the event
of default. As a result, high-yield debt can have lower
losses given default than unsecured bonds of an
investment grade issuer. The greatest risk to the
investors in unsecured investment grade debt is not an
increase in loss given default, but an increase in the
probability of default due to deterioration in the
issuerÕs financial situation.
 Describe the uses of ratings from credit rating
agencies and their limitations.

Credit rating agencies assign forward-looking ratings to

both the issuers of bonds and their debt issues, based
on qualitative and quantitative credit risk factors.

Uses of credit ratings include the following:

o Comparing the credit risk of issuers across industries
and bond types, and assessing changing credit conditions
over time.
o Assessing credit migration risk, the risk that a credit
rating downgrade will decrease the value of the bonds
and potentially trigger other contractual clauses.
o Meeting regulatory, statutory, or contractual
requirements.
Triple A (AAA or Aaa) is the highest rating. Bonds with
ratings of Baa3/BBB- or higher are considered
investment grade. Bonds rated Ba1/BB+ or lower are
considered non-investment grade and are often called
high-yield bonds or junk bonds.

Bonds in default are rated D by Standard & PoorÕs and

Fitch and are included in MoodyÕs lowest rating category,
C.
Relying on ratings from credit rating agencies has some
risks:
1. Credit ratings lag market pricing. Market prices and
credit spreads can change much faster than credit
ratings. Additionally, two bonds with the same rating can
trade at different yields because credit ratings focus
on expected loss, whereas market pricing for distressed
debt focuses more on default timing and expected
recoveries.
2. Some risks are difficult to assess. Risks such as
litigation, natural disasters, environmental risks,
acquisitions, and equity buybacks using debt are not
easily predicted, or captured in credit ratings. Agencies
may take different views on the likelihood of such
events, leading to split ratings where the same debt
issue gets assigned different ratings from different
agencies.
3. Rating agencies are not perfect. Mistakes occur from
time to time. Infamously, subprime mortgage securities
were assigned much higher ratings than they deserved
in the lead-up to the global financial crisis of 2008–
2009. Cases of corporate fraud can also lead to
companies with high credit ratings suddenly defaulting.
Investors should also do their own due diligence when
assessing credit risk and not rely purely on credit
ratings. Investors who trade correctly in anticipation of
credit rating changes will experience far superior
performance to those who trade in reaction to rating
changes.
Describe macroeconomic, market, and issuer-specific
factors that influence the level and volatility of yield
spreads.
Credit spread risk is the risk that yield spreads widen
due to deteriorating conditions, causing credit-risky
bond prices to decrease. This is a primary concern for
investment grade bond investors because default is
unlikely to occur suddenly. A more realistic concern is
that spreads widen and prices fall as credit conditions
worsen. Credit spread risk arises from macroeconomic,
issuer-specific, and market (trading related) factors.

Macroeconomic Factors
Credit risk changes largely in line with the economic
cycle. In times of strong growth and high profits, the
probability of default decreases, causing spreads to
contract; at times of recession, the probability of
default increases, causing spreads to widen.
 Credit spreads for high-yield issuers may behave
differently than credit spreads for investment grade
issuers over a business cycle. Examples of the typical
behavior of both are as follows:

Investment grade issuers have lower yield spreads than

high-yield issuers due to their lower expected loss.

Yield spreads usually increase with maturity because the

probability of default increases over longer time
frames, giving rise to upward-sloping credit spread
curves (plots of credit spread vs. maturity).

– During economic contractions (recessions), high-yield and

investment grade credit curves rise and flatten as the
probability of a near-term default increases. The high-yield
credit curve may even invert (turn downward sloping) in this
stage of the economic cycle.
– During economic expansions, high-yield and investment
grade credit curves fall and steepen as the probability of a
near-term default decreases. Credit curves will be lowest
and most steep at the peak of the cycle.

Across issuers, the dispersion of yield spreads for high-

yield issuers is higher than for investment grade
issuers.

High-yield spreads tend to fluctuate more than

investment grade spreads as economic conditions
change. High-yield spreads can widen dramatically in
times of crisis as investors sell riskier assets and buy
safer ones in a flight to quality. Because high-yield
issues tend to be less liquid, bid–offer spreads for high-
yield debt may widen more than for investment grade
debt in times of crisis.
It is clear that owning high-yield bonds is riskier than
holding investment grade bonds from a credit spread
risk perspective because spreads are more volatile for
high-yield issuers. The incentive to do so is the greater
yield spread offered by high yield debt. Other
incentives for exposure to this higher credit spread risk
include the following:

Diversification. High-yield bond prices have low or even

negative correlation with investment grade bonds, so
they can diversify a fixed-income portfolio.

Capital appreciation. The larger spread changes for

high-yield issues produce larger price gains during
economic recoveries compared to investment grade
issues.

Equity-like returns. According to some empirical data,

high-yield debt offers equity-like returns with lower
volatility than equity markets.
Other systematic factors that can drive yield spreads
higher include the following:
Increasing regulations of broker-dealers and market
makers in corporate bonds have increased the cost of
funding bond positions.
Funding stresses in markets may increase risk aversion.
Heavy new issuance of debt into bond markets might
not be met by increased demand.

Issuer-Specific Factors
As noted previously, the financial performance of the
issuer will have a significant impact on the yield spread
level and volatility on their debt. Investors often
compare an issuerÕs yield spread to the average yield
spread offered by bonds of a similar credit rating to
assess issuer-specific concerns. For an issuer with
problems servicing its debt, yield spreads will be wider
than the average for the issuerÕs credit rating.
Market Factors
Market liquidity risk relates to the transaction costs
of trading a bond. It can be assessed through analyzing
the bid–offer spreads of market makers in a bond. The
bid is the price at which investors can sell bonds, while
the offer is the price at which investors can buy. A
wider bid–offer spread implies higher costs of trading
to investors and indicates higher market liquidity risk.
Generally, issuers with more debt outstanding or with
higher credit ratings will have more actively traded
bonds (and therefore narrower bid–offer spreads) with
less market liquidity risk. Market liquidity risk is higher
for less actively traded bonds, for issuers with lower
credit quality, and for issuers with less debt outstanding
in bond markets.
Bid–offer spreads can widen substantially for high-yield
issuers during times of financial stress as market
liquidity falls dramatically. This can lead to a general
increase in risk aversion, which may cause wider bid–
offer spreads to spill over to investment grade issuers.
The bid–offer spreads of market makers can be used to
isolate the component of the yield spread that is due to
liquidity risk. This is done by calculating the yield at the
bid and offer prices, and assuming this difference is
reflected in the yield spread of the bond as
compensation for liquidity risk. The remaining component
of the yield spread is assumed to be related to the
credit risk of the issuer.
Example:

A 10-year bond has an annual coupon of 5% and a bid–

offer spread of 99.5/100.5. The benchmark 10-year
yield is 3%. Decompose the yield spread into liquidity
spread and credit spread.
We have seen that the sensitivity of a bondÕs price to a
change in yield can be estimated using the bondÕs
duration and convexity. We can also use these measures
to estimate the price impact of a change in spread,
simply by replacing the yield change (ΔYTM) with the
spread change (ΔSpread):