(R47) Fundamentals of Credit Analysis

Question 1

Define Credit Risk and list the two components

Answer 1

Credit risk is the risk of not receiving full interest and principal payments on a timely basis; Two components include: default risk and loss severity

Question 2

Default Risk (Probability)

Answer 2

Risk that the issuer or company doesn’t make its required payments (This is the focus of high-quality debt issuers)

Question 3

Loss Severity

Answer 3

The size of the loss given the event of default (This is the focus of low-quality debt issuers)

Question 4

Expected loss =

Answer 4

Default risk x loss severity

Question 5

Downgrade risk

Answer 5

The risk that a bonds issuer’s creditworthiness deteriorates, or migrates lower, leading investors to believe the risk of default is higher (AKA credit migration risk)

Question 6

Two broad categories of seniority ranking

Answer 6

Secured and unsecured; secured always gets paid first

Question 7

Secured capital structure includes

Answer 7

First lien/mortgage debt (highest) to senior secured (lowest of group)

Question 8

Unsecured capital structure includes

Answer 8

Senior unsecured to junior subordinated

Question 9

Recovery rates vary by the following

Answer 9

1. seniority
2. industry
3. stage of credit cycle

Question 10

Why would two bonds with equal ratings have different prices?

Answer 10

Due to different recovery rates and different outlook

Question 11

Two broad categories of credit ratings

Answer 11

1. Investment grade (AAA to BBB-)

2. Non-investment grade (BB+ to D)

Question 12

Issuer credit rating vs. issue credit rating

Answer 12

• Issuer credit rating- Addresses the obligor’s (the company’s) overall creditworthiness (applies to senior unsecured debt).
• Issue credit rating - refers to specific bonds of an issuer

Question 13

When does issuer credit rating = issue credit rating

Answer 13

When bond rating is AAA only

Question 14

Investment grade vs. non-investment grade; which has lower default and liquidity premiums?

Answer 14

Investment grade

Question 15

Notching

Answer 15

• Rating agency practice where specific issues from the same borrower may be assigned different credit ratings;
• Investment grade: Issue is 1 notch +/- issuer (primary focus is the probability of default
• Non-investment grade: issue is 2 notches below issue (primary focus is on the recovery rate

Question 16

List the four C’s of credit analysis

Answer 16

1. Capacity
2. Collateral
3. Covenants
4. Character
   These asses the ability to pay and look and credit quality and industry fundamentals

Question 17

Capacity (4 C’s of credit analysis)

Answer 17

Ability to pay on time; to determine this, look at the industry analysis/structure (porters framework), industry fundamentals, and company fundamentals

Question 18

Collateral (4 C’s of credit analysis)

Answer 18

Focus is on the estimated loss (1 - recovery rate) and involves estimates of market value

Question 19

Covenants

Answer 19

Affirmative (mgmt. is obligated to do) vs. negative (mgmt. limited in doing)

Question 20

Character

Answer 20

Track record, poor strategy and policies, poor treatment of bond holders

Question 21

Yield on corporate bond =

Answer 21

Benchmark rate + spread

Question 22

Spread =

Answer 22

liquidity premium and credit spread

Question 23

Factors that affect credit risk (credit spread)

Answer 23

1. Credit cycle
2. economic conditions
3. financial market performance
4. Supply and demand

Question 24

Special considerations of High Yield Bonds when performing credit analysis

Answer 24

• Non-investment grade (rated below Baa3/BBB)
• More interested in loss severity
• Greater focus on liquidity
• Top heavy capital structure
• structural subordination

Question 25

Special considerations of Sovereign Debt when performing credit analysis

Answer 25

• Focused on the ability and willingness to pay
• Sovereign governments have immunity and don’t have to pay investors
• Must look at political and economic factors

Question 26

Special considerations of Municipal debt when performing credit analysis

Answer 26

• Municipalities must balance their budgets
• General obligations bonds (unsecured)
• Revenue bonds (issued for specific projects)

Question 27

Market liquidity risk

Answer 27

Risk that the price at which investors transact may be different from the price indicated in the market; increased by less debt outstanding and/or a lower credit rating

Question 28

Debt/capital ratio and debt/EBITDA ratio are what type of ratios?

Answer 28

Leverage ratios; The higher the ratios, the more credit risk

Question 29

Coverage ratios measure?

Answer 29

Measure an issuer’s ability to meet its interest payments