Module 60: Credit risk

Question 1

What is credit risk?

Answer 1

Credit risk is the risk associated with losses to fixed income investors stemming from the failure of a borrower to make payments of interests/princiapsl

Question 2

What is default?

Answer 2

When a borrower fails to make payment

Question 3

What are the bottom up drivers of credit factors?

Answer 3

These are issuer specific factors, examples of which:
Capacity: This is the borrowers ability to make their payments on time
Capital: Other resources available to the borrower which can reduce it’s reliance on debt e.g. assets being sold off
Collateral: Quality of assets pledged to provide the lender with security in the event of a debt
Covenants: The legal terms that the borrower and issuer must comply with
Character: The borrowers integrity and quality of management and their willigness to make payment under their debt obligations.

Question 4

What are the Top Down drivers of credit factors?

Answer 4

These are general economic factor:
Conditions: This is the general economic enviroment (faced by all the borrowers in the economy)
Country: The geopolitical enviroment (wars/conflict), quality of legal and political system
Currency: Foreign exchange flucuations and it’s impact

Question 5

How are secured and unsecured bonds paid for?

Answer 5

Secured: Operating Cash Flows and Proceeds of the sale of collateral
Unsecured Bonds: Operating Cash Flows
Soverign Bonds: Proceeds from the raise of tax

Question 6

What is the difference between an illiquid and insolvent borrower?

Answer 6

Illiquid: A borrower who cannot make debt payment due to insufficiency of resources
Insolvent: Possess assets that are lower than their liability, but they may be able to pay their debts

Question 7

What is the cash flow for corporate borrowers?

Answer 7

Primary: Business Operations, Investment Activities, Financing Activities
Secondary: Asset sales,

Question 8

How do Sovereign issuers raise money

Answer 8

Primary: Taxation (corporate + individual), VAT, Capital gains Tax, Tarriffs
Secondary: Privatisation, issuing debt

Question 9

Where can credit risk for a corporate issuer come from?

Answer 9

Poor economic and market conditions, increase competition, low profitability and excessive debt

Question 10

What is a cross default clause?

Answer 10

Means a default on one bond issue causes a default on all issues

Question 11

What is a pari passu clause

Answer 11

All bonds of a certain type rank equally in the default process

Question 12

How do these clauses differ for unsecured and secured debtholders?

Answer 12

Unsecured: A default on one of this clauses means all holders have access to the general assets of the issuer
Secured: Only have access to the assets pledged as collateral, only when the value of the assets fall, will a secured bond investor suffer credit losses.

Question 13

How do you measured Credit Risk?

Answer 13

Expected Loss (EL) = Probability of default x loss given default

Question 14

What is probability of default

Answer 14

It is the likelyhood that the issuer will default

Question 15

What is the loss given default.

Answer 15

This is the loss to the investor if a default occurs.
Calculated: Exepcted Exposure x (1 - Recovery Rate)
Expected Exposure:
The size of the investors claim
Amount investor is owed (principal & interest) - value of collateral available to repay
1 - Recovery Rate: The unrecovered portion of the claim

Question 16

How are investors compensated for this extra credit risk

Answer 16

You are given a yield above a risk free benchmark (credit spread)
Calculated = Probability of default x LGD%

Question 17

What factors influence Probaility of Default?

Answer 17

1. Profitability -> If they can generate stable predictable profit
   Measured by EBIT margiin,
2. Coverage: Ensuring we have adequate cash flows to cover our interest related expenses
   Measured by EBIT/Interest
3. Leverage: Measure of the relative reliance of a company on debt financing
   Measured by Debt/EBIDTA

Question 18

How does LGD differ

Answer 18

LGD is to do with the nature and seniority of a specific debt claim

Question 19

How are the main credit rating agencies? What do credit rating agencies do?

Answer 19

Main providers: S&P, Moody’s and Fitch
Purpose: They provide forward looking independent asessment of issuer credit risk of a quantatitive and qualitative nature

Question 20

What does the rating measure?

Answer 20

It is a symbol based measure of Probability of Default

Question 21

What do we use credit ratings for?

Answer 21

Comparing the credit risk of issuers across industries and bond types, and assessing changing credit conditions over time.
Assessing credit migration risk, the risk that a credit rating downgrade will decrease the value of the bonds and potentially trigger other contractual clauses.
Meeting regulatory, statutory, or contractual requirements.

Question 22

What is investment grade bonds

Answer 22

Aaa-Baa3 (Moody), AAA-BBB- (S&P, Fitch)

Question 23

What are the risks for relying on credit rating agencies?

Answer 23

1. Credit ratings are sticky: They dont change often enough and may lag market prices and credit spreads
2. Risks are difficult to assess, such as litiation aand national disasters, such as acquisitions, equity buy backs and debt + agencies may take different views on the likelihood of such events (leading to split ratings where different agencies provide divergent ratings)
3. Rating agencies are not perfect: Mistakes occur from time to time

Question 24

What affect yield (credit spread)

Answer 24

Macroeconomic factors, issuer specific factors, and market factors

Question 25

What's the business cycles and credit spreads

Answer 25

Credit spread change in line with the economic cycle Strong growth = less likely to default Recession = more likely to default

Question 26

How do the credit spread of investment grade issuers differ from high yield issuers?

Answer 26

Investment grade: Lower yield spreads High Yield: Higher yield spreads

Question 27

What affect does higher maturity have on yield spreads

Answer 27

Higher maturity usually brings higher yields due to an increase in possibility of default

Question 28

How do yield curves change depending on the stage of the economic cycle

Answer 28

Recession: 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. Growth: high-yield and investment grade credit curves fall and steepen as the probability of a near-term default decreases.

Question 29

What are some incentives for higher credit spreads

Answer 29

Diversiification: Can diversify an FI portfolio Capitla Appreciate: The larger spreads can cause large price gains when the economy recovers Equity like returns: High Yield debt offers equity like returns with lower volatility

Question 30

What factos can drive yield spreads higher?

Answer 30

* 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.

Question 31

What are issuer specific factors that influence market spread yields

Answer 31

Investors often compare an issuer's 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 issuer's credit rating.

Question 32

# s What are market specific factors that influence market spread yields

Answer 32

Market Liquidity Risk: The risk related to the transaction costs of trading a bond, often assessed through bid-offer spreads. Wider spreads indicate higher liquidity risk.

Question 33

What is the bid price in bond trading?

Answer 33

The price at which investors can sell bonds.

Question 34

What factors generally lead to lower market liquidity risk (narrower bid-offer spreads)?

Answer 34

Issuers with more debt outstanding, higher credit ratings, and more actively traded bonds.

Question 35

What factors generally lead to higher market liquidity risk (wider bid-offer spreads)?

Answer 35

Less actively traded bonds, lower credit quality, and less debt outstanding in bond markets.

Question 36

How can bid-offer spreads widen significantly, even for investment-grade issuers?

Answer 36

During times of financial stress, when market liquidity falls and risk aversion increases. High-yield issuers are particularly vulnerable.

Question 37

How can bid-offer spreads be used to isolate the liquidity risk component of a yield spread?

Answer 37

(1) Find the midprice quote - this will be FC (2) Calculate the yield spread over the benchmark yield (3) By calculating the yield at both the bid and offer prices; the difference is assumed to represent compensation for liquidity risk. (4) Minus the liquidity spread from the yield soread - the remaining spread is attributed to credit risk.