BCOM: FIXED INCOME

(FIXI01-7)
WELCOME

• The aim of this session is to guide you as students through the course
content.

• The content covered in this session may not be exhaustive of the

entire curriculum and we recommend that students cover all of the
content in the curriculum in preparation for the exam.
 TOPIC 5
Fundamentals of credit analysis
• In this topic, you will gain knowledge in the following areas:

1. Credit risk

2. Capital structure, seniority ranking and recovery rates

3. Ratings agencies, credit ratings and their role in debt markets

4. Traditional credit analysis: corporate debt securities

5. Credit risk versus return: yields and spreads

6. Special considerations of high yield and sovereign/municipal credit analysis
Credit Risk

❖ Credit risk stems from the probability of loss, where a borrower fails to make timely
and due payment of interest and capital. Credit risk has two facets:

➢ Default risk is the probability that a borrower (bond issuer) will fail to pay interest and
principal on loans when they become due.

➢ Loss severity refers to the amount that the investor will lose if a credit defaults.

The expected loss = default risk × loss severity

❖ Recovery rate is the percentage of a bond’s value that investors will recover in the
event of default.

❖ Loss severity is often expressed as (1 – Recovery rate).

Credit Risk

❖Bonds with greater credit risk will offer higher yields, with the difference
between these issues and risk-free issues being the yield spread.
❖The current spread between risk-free securities and the issue in question
may widen because of one or both of the following factors:
➢ Credit migration risk or downgrade risk, where the issuer becomes less
creditworthy.
➢ Market liquidity risk refers to the possibility of selling a particular issue for
less than market value, and is reflected in the size of the bid-ask spreads.
Seniority Ranking

❖ Each category of debt from the same issuer is ranked according to the priority of claims
in the event of a default.

❖ A particular issuer’s assets and cashflows are referred to as its seniority ranking.
❖ The debt may be either secured (backed by collateral) or unsecured (known as
debentures) representing a general claim on the issuer’s assets.

❖ Secured debt can be further segmented as first lien (backed by pledge of specific
assets), senior secured debt and junior secured debt.

❖ In terms of ranking, this is followed by unsecured debt, which is divided into senior
debt, junior debt and subordinated debt.

❖ This is the order according to which debt is recovered. It is important to remember that
priority in the event of bankruptcy is not certain and may rely on a specific judge or court.
Recovery rates

❖ Recovery rates vary by seniority of ranking in a company’s capital structure, under the
priority of claims treatment in bankruptcy.

❖ Recovery rates can vary widely by industry.

❖ Recovery rates can also vary depending on when they occur in a credit cycle.
❖ Recovery rates are averages due to large variability, both across industries, as well
as across companies within a given industry.
Ratings Agencies, Credit Ratings and their
Role in Debt Markets
❖ The 3 major global credit rating agencies—Moody’s, S&P Global, and Fitch—use similar,
symbol-based ratings that are basically an assessment of a bond issue’s risk of default
Ratings Agencies, Credit Ratings and their
Role in Debt Markets

❖ There are risks to relying solely on credit rating agency ratings.

a) Credit ratings are dynamic and change with time; agencies may update their
default risk assessments during the life of the bond, but higher credit ratings tend to
be more stable.
b) Ratings are not perfect and sometimes agencies make mistakes – as highlighted by
the financial crisis, where default risk was not accurately assessed.
c) Event risk is difficult to assess. Industry or company-specific risks are difficult to
predict and incorporate into credit ratings (for example, the legal risk associated with
tobacco companies).
d) Credit ratings cause market pricing to lag. Market prices and credit spreads
change at a faster rate than credit ratings.
Traditional Credit Analysis: Corporate Debt
Securities

a) Capacity
❖ Capacity refers to the borrower’s ability to repay the obligation on time. This can be
linked to a similar process used in equity analysis, which deals with three levels of
assessment:

➢ Industry structure: Porter’s five forces model (Threat of entry; power of suppliers;
power of buyers/customers; threat of substitutes; rivalry among existing competitors).
The stronger the industry the more likely the issuer will be able to repay its
obligations.

➢ Industry fundamentals: Industry cyclicality, growth prospects and other statistics.

➢ Company fundamentals: Competitive position, operating history, management

strategy and execution, and ratio analysis.
Traditional Credit Analysis: Corporate Debt
Securities
b) Collateral
❖ Collateral is more important for less creditworthy companies, as they will likely be
required to provide a form of security. The following issues are important to consider:

➢ Intangible assets

➢ Depreciation

➢ Equity market capitalisation

➢ Human and intellectual capital

Traditional Credit Analysis: Corporate Debt
Securities
c) Covenants

❖ Covenants are the terms and conditions of the loan agreement.

➢ Affirmative covenants require borrowers to take selected actions.

➢ Negative covenants restrict the borrower from taking certain actions.

Traditional Credit Analysis: Corporate Debt
Securities
d) Character
❖ Character refers to management’s integrity and their commitment to repaying the
loan. The following is usually assessed:

➢ management’s ability to develop a sound strategy,

➢ management’s use of transparent accounting policies and tax strategies etc.

Credit Risk vs Return: Yields and Spreads

❖ Corporate bonds investors focus primarily on the yield spread relative to a

comparable, default-free bond, which is composed of the liquidity premium and the
credit spread.

❖ The return or yield of an option-free corporate bond is the sum of the real risk-free
rate, the expected inflation rate, a maturity premium, a liquidity premium and a credit
spread to compensate for the risk of the specific issue.

Yield spread = Liquidity premium + Credit spread

Credit Risk vs Return: Yields and Spreads
❖ Yield spreads of corporate bonds are primarily affected by the following interrelated
factors:

a) Credit cycle:- the market’s perception of overall credit risk is cyclical.

b) Economic conditions:- credit spreads narrow as the economy strengthens and
investors expect credit metrics to improve.

c) Financial market performance:- credit spreads narrow in strong-performing markets

overall and widen in weak-performing markets.

d) Broker-dealer capital:- yield spreads narrow when broker-dealers provide sufficient

capital, but widen when market-making capital is scarce.

e) General market demand and supply:- credit spreads narrow in times of high
demand for bonds. In periods of heavy new issue supply, credit spreads will widen if
there is insufficient demand.
High Yield, Sovereign and Municipal Credit
Analysis
❖ High-yield bonds are more likely to default than investment grade bonds, which
increases the importance of estimating loss severity.

❖ Credit risk of sovereign debt includes the issuing country’s ability and willingness to
pay its obligations.

➢ Ability for debt issued in own currency than in a foreign currency.

➢ Willingness is the possibility that a country may refuse to honour its obligations.
❖ Analysis of general obligation municipal debt is similar to sovereign debt (focus is on
the strength of the local economy and its effect on tax revenues). Analysis of
municipal revenue bonds mirrors corporate debt (focus is on the ability of a project to
generate sufficient revenue to service the bonds).
Closing Comments

END!