5.2 Credit Risk

5.2.1 Credit Risk and Credit-Related Risks Affecting Corporate Bonds

5.2.1.1 Credit Risk Credit risk is the risk of loss resulting from the borrower (issuer of debt) failing to make full and timely payments of interest and/or principal.

Credit Risk Components:

Default Risk (default Probability) – the probability that a borrower defaults-that is, fails to meet its obligation to make full and timely payments of principal and interest, according to the terms of the debt security
Loss Severity (Loss given Default) – in the event of default, the portion of a bond's value (including unpaid interest) an investor loses Because default risk (default probability) is quite low for most high-quality debt issuers, bond investors tend to focus primarily on assessing this probability and devote less effort to assessing the potential loss severity arising from default. However, as an issuer's default risk rises, investors will focus more on what the recovery rate might be in the event of default.

Expected Loss

The recovery rate is the percentage of the principal amount recovered in the event of default.

5.2.1.2 Credit-Related Risks Important credit-related risks include the following:

Spread Risk: The risk of changing (widening) the credit spread on the bond over a certain benchmark. As a result, the spread may change. The spread or yield premium on corporate bonds includes a market liquidity component in addition to a credit risk component to compensate investors for the risk that there may not be sufficient market liquidity for them to buy or sell bonds in the quantity they desire.
Downgrade Risk: The risk that a bond issuer's creditworthiness deteriorates.

Downgrade risk (i.e., credit migration risk) results from the action of credit rating agencies and may lead investors to believe the risk of default is higher, thus causing the yield spreads on the issuer's bonds to widen and the price of its bonds to fall.

Market Liquidity Risk: The risk that the price at which investors can actually transact- buy or sell-may differ from the price indicated in the market. Market liquidity is directly related to the size of the issue and quality of the issuer.

5.2.2 Seniority Ranking of Corporate Bonds

The seniority ranking refers to the priority of payment, with the most senior or highest-ranking debt having the first claim on the cash flows and assets of the issuer. This level of seniority can affect the value of an investor's claim in the event of default and restructuring. The composition and distribution across operating units of a company's debt and equity-including bank debt, bonds of all seniority rankings, preferred stock, and common equity-is referred to as its capital structure.

Broadly, there is secured debt and unsecured debt:

Secured debt means the debtholder has a direct claim, a pledge from the issuer, on certain assets and their associated cash flows.
Unsecured debt means the debtholder has only a general claim on an issuer's assets and cash flow. Unsecured bonds are often referred to as debentures. In the event of default, unsecured debtholders' claims rank below (i.e., get paid after) those of secured creditors under what's known as the priority of claims.

5.2.2.1 Seniority Ranking 1. First lien loan – Senior secured 2. Second-lien loan – Secured 3. Senior Unsecured 4. Senior Subordinated 5. Subordinated 6. Junior Subordinated Within each category of debt, there are finer gradations of types and rankings.

There are many reasons why companies issue-and investors buy-debt with different seniority rankings. Issuers are interested in optimizing their cost of capital-finding the right mix of the various types of both debt and equity-for their industry and type of business.

5.2.2.2 Recovery Rates All creditors at the same level of the capital structure are treated as one class. This provision is referred to as bonds ranking pari passu ("on an equal footing") in right of payment.

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; there can be wide variability from case to case.

In theory, the priority of claims in bankruptcy-the idea that the highest-ranked creditors get paid out first, followed by the next level, and so on-is well established. In practice, there might be violations.

In principle, in the event of bankruptcy or liquidation:

Creditors with a secured claim have the right to the value of that specific property before any other claim. If the value of the pledged property is less than the amount of the claim, then the difference becomes a senior unsecured claim.
Unsecured creditors have a right to be paid in full before holders of equity interests (common and preferred shareholders) receive value on their interests.
Senior unsecured creditors take priority over all subordinated creditors. A creditor is senior unsecured unless expressly subordinated.

5.2.3 Potential Violation of the Priority of Claims in a Bankruptcy Proceeding

In bankruptcy, there are different classes of claimants, and all classes that are impaired (that is, receive less than full claims) get to vote to confirm the plan of reorganization.

Bankruptcy and bankruptcy laws are very complex and can vary greatly by country, so it is difficult to generalize about how creditors will fare.

There may be disputes over the value of various assets in the bankruptcy estate or the present value or timing of payouts.
Resolution of these disputes takes time, and cases can drag on for months and years.
Thus, to avoid the time, expense, and uncertainty over disputed issues, the various claimants have an incentive to negotiate and compromise.
This frequently leads to creditors with lower seniority and other claimants (e.g., even shareholders) receiving more consideration than they are legally entitled to receive.

5.2.4 Corporate issuer Credit Ratings

Issuer credit ratings address an obligor's overall creditworthiness-its ability and willingness to make timely payments of interest and principal on its debt.

Rating agencies will typically provide both issuer and issue ratings, particularly as they relate to corporate debt.

The issuer credit rating usually applies to its senior unsecured debt.

The three major global credit rating agencies- Moody's Investors Service, S&P, and Fitch Ratings-use symbol-based ratings that are basically an assessment of a bond issue's risk of default.

Rating agencies will also typically provide outlooks on their respective ratings: positive, stable, or negative.

In support of their ratings, the rating agencies provide extensive written commentary and financial analysis on the obligors they rate, as well as summary industry statistics.

5.2.5 Issue Credit Ratings

Refer to specific financial obligations of an issuer and take into consideration such factors as ranking in the capital structure.

Although cross-default provisions-whereby events of default such as non-payment of interest on one bond trigger default on all outstanding debt-implies the same default probability for all issues, specific issues may be assigned different credit ratings.

5.2.6 Rating Agency Practice of "Notching"

For the rating agencies, the likelihood of default-default risk-is the primary factor in assigning their ratings.

The secondary factors include the priority of payment in the event of a default as well as the potential loss severity in the event of default.

Notching refers to the process of moving up or down credit ratings on issues from the issuer rating, which is usually the rating applied to its senior unsecured debt.

Notching process is made possible by recognizing these different payment priorities, and thus the potential for higher (or lower) loss severity in the event of default.

As a general rule, the higher the senior unsecured rating, the smaller the notching adjustment will be. The reason behind this is that the higher the rating, the lower the perceived risk of default, so the need to "notch" the rating to capture the potential difference in loss severity is greatly reduced.

For lower-rated credits, however, the risk of default is greater and thus the potential difference in loss from a lower (or higher) priority ranking is a bigger consideration in assessing an issue's credit riskiness.

5.2.7 Risks in Relying on Ratings from Credit Rating Agencies

The ratings of the three major rating agencies have proved quite accurate as a relative measure of default risk, apart from a few exceptions.

There are limitations and risks, however, to relying on credit rating agency ratings, including the following:

Credit ratings can change over time – Over a long time period (e.g., many years), credit ratings can migrate-move up or down-significantly from what they were at the time of bond issuance. Therefore, bond investors should not assume an issuer's credit rating will remain the same from the time of purchase through the entire holding period.
Credit ratings tend to lag the market's pricing of credit risk – Bond prices and credit spreads frequently move more quickly because of changes in perceived creditworthiness than rating agencies change their ratings (or even outlooks) up or down.
Rating agencies may make mistakes.
Some risks are difficult to capture in credit ratings e.g. litigation risk, such as that that can affect tobacco companies, or environmental and business risks faced by chemical companies and utility power plants.

5.2.8 Components of Traditional Credit analysis

The goal of credit analysis is to assess an issuer's ability to satisfy its debt obligations, including bonds and other indebtedness, such as bank loans.

Many analysts perform a so-called 4C analysis 1. Capacity – refers to the ability of the borrower to make its debt payments on time.

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

3. Covenants – are the terms and conditions of lending agreements that the issuer must comply with.

4. Character – refers to the quality of management.

The main focus in credit analysis is to understand a company's ability to generate cash flow over the term of its debt obligations. In so doing, analysts must assess both the credit quality of the company and the fundamentals of the industry in which the company operates.

Traditional credit analysis considers the sources, predictability, and sustainability of cash generated by a company to service its debt obligations.

1. Capacity Capacity is the ability of a borrower to service its debt. To determine that, credit analysis starts with industry analysis and then turns to examination of the specific issuer.

Industry Analysis
Industry Structure Analysis Porter's framework of analyzing five competitive forces is useful for the analysis of an industry structure:
The threat of entry – The threat of entry depends on the extent of barriers to entry and the expected response from incumbents to new entrants.
Power of Suppliers – An industry that relies on just a few suppliers tends to be less profitable and to have greater credit risk than an industry that has multiple suppliers.
Power of Buyers/Customers – Industries that rely heavily on just a few main customers have greater credit risk because the negotiating power lies with the buyers.
Threat of Substitutes – Industries (and companies) that offer products and services that provide great value to their customers, and for which there are not good or cost-competitive substitutes, typically have strong pricing power, generate substantial cash flows, and represent less credit risk than other industries or companies.
Rivalry among Existing Competitors – Industries with strong rivalry-because of numerous competitors, slow industry growth, or high barriers to exit-tend to have less cash.
Industry Fundamental Analysis After understanding an industry's structure, the next step is to assess its fundamentals, including its sensitivity to macroeconomic factors, its growth prospects, its profitability, and its business need-or lack thereof-for high credit quality.

Judgments about these can be made by looking at the following

Cyclical or non-cyclical industry – Industries that are cyclical-that is, have greater sensitivity to broader economic performance-have more volatile revenues, margins, and cash flows and thus are inherently riskier than non-cyclical industries.
The industry's growth prospects – Industries that have little or no growth tend to consolidate via mergers and acquisitions. Depending on how these are financed (e.g., using stock or debt) and the economic benefits (or lack thereof) of the merger, they may or may not be favorable to corporate bond investors.
Published industry statistics – Analysts can get an understanding of an industry's fundamentals and performance by researching statistics that are published by and available from a number of different sources, including the rating agencies, investment banks, industry publications, and frequently, government agencies.
Company Fundamental Analysis Following analysis of an industry's structure and fundamentals, the next step is to assess the fundamentals of the company: the corporate borrower.

Analysts should examine the following:

Competitive position – Analysis of a company's competitive position within the industry includes answering the following questions: What is its market share? How has it changed over time: Is it increasing, decreasing, or holding steady? Is it well above (or below) its peers? How does it compare with respect to cost structure? How might it change its competitive position? What sort of financing might that require?
Track record/operating history – Analysis of a company's track record includes answering the following questions: How has the company performed over time? What are the trends in revenues, profit margins, and cash flow? Capital expenditures represent what percent of revenues? What are the trends on the balance sheet-use of debt versus equity? Was this track record developed under the current management team? If not, when did the current management team take over?
Management's strategy and execution – Analysis of management's strategy includes answering the following questions: What is management's strategy for the company- to compete and to grow? Does it make sense, and is it plausible? How risky is it, and how differentiated is it from its industry peers? Is it venturing into unrelated businesses? Does the analyst have confidence in management's ability to execute?

What is management's track record, both at this company and at previous ones? Does management plan to manage the balance sheet prudently, in a manner that doesn't adversely affect bondholders?

Ratios and ratio analysis – Key credit analysis measures can be split into the following three groups:
Profitability and cash flow
Leverage
Coverage It is from profitability and cash flow generation that companies can service their debt.

Credit analysts typically look at operating profit margins and operating income to get a sense of a company's underlying profitability and see how it varies over time. The leverage ratios represent a measure of financial risk. Coverage ratios measure an issuer's ability to meet-to "cover"-its interest payments.

Ratio and ratio analysis give context to analysis and understanding company's fundamentals in relation to the industry, competitive position, strategy and execution.

Access to Liquidity An issuer's access to liquidity is also an important consideration in credit analysis. When assessing an issuer's liquidity, credit analysts tend to look at the following:
Cash on the balance sheet – Cash holdings provide the greatest assurance of having sufficient liquidity to make promised payments.
Net working capital – A company may have negative working capital, despite having high levels of cash on the balance sheet.
Operating cash flow – Analysis of liquidity available for the day-to-day operations.
Committed bank lines – Committed but untapped lines of credit provide contingent liquidity in the event that the company is unable to tap other, potentially cheaper, financing in the public debt markets.
Debt coming due and committed capital expenditures in the next one to two years – Analysts will compare the sources of liquidity with the amount of debt coming due as well as with committed capital expenditures to ensure that companies can repay their debt and still invest in the business if the capital markets are somehow not available.

2. Collateral Collateral, or asset value, analysis is typically emphasized more with lower-credit-quality companies. Only when the default probability rises to a sufficient level do analysts typically consider asset or collateral value in the context of loss severity in the event of default.

Analysts do think about the value and quality of a company's assets; however, these are difficult to observe directly. Factors to consider include the nature and amount of intangible assets on the balance sheet.

3. Covenants Covenants are meant to protect creditors while also giving management sufficient flexibility to operate its business on behalf and for the benefit of the shareholders. They spell out what the issuer's management is (1) obligated to do (affirmative) and (2) limited in doing (negative).

Covenants are an important but underappreciated part of credit analysis. Strong covenants protect bond investors from the possibility of management taking actions that would hurt an issuer's creditworthiness.

4. Character Credit analysts can make judgments about management's character in the following ways:

An assessment of the soundness of management's strategy
Management's track record in executing past strategies, particularly if they led to bankruptcy or restructuring. A company run by executives whose prior positions/ventures resulted in significant distress might still be able to borrow in the debt markets, but it would likely have to borrow on a secured basis and/or pay a higher rate of interest.
Use of aggressive accounting policies and/or tax strategies, e.g. aggressive accounting might include using a significant amount of off-balance-sheet financing, capitalizing versus immediately expensing items, recognizing revenue prematurely, and/or frequently changing auditors.
Any history of fraud or malfeasance
Previous poor treatment of bondholders, such as a debt-financed acquisition, a large special dividend to shareholders, or a major debt-financed stock buyback program.

Lesson Wrap-Up

This lesson should leave you able to explain the credit risk in a fixed-income context and connect it to the decisions made by issuers, investors, or analysts.

Review Prompts

Explain credit risk and credit-related risks affecting corporate bonds in your own words.
Explain seniority ranking of corporate bonds in your own words.
Explain potential violation of the priority of claims in a bankruptcy proceeding in your own words.
State one exam-style risk, valuation, or market implication of the credit risk.