Fundamentals of Credit Analysis

LM: CREDIT RISK
LM: CREDIT ANALYSIS FOR GOVERNMENT

ISSUERS
LM: CREDIT ANALYSIS FOR CORPORATE ISSUERS
FUNDAMENTALS OF CREDIT ANALYSIS
LOS a: Describe credit risk and credit-related risks affecting corporate bonds.
LOS b: Describe default probability and loss severity as components of credit risk.
 Credit risk refers to the risk of loss resulting from a borrower's failure to make full
and timely payments of interest and/or principal. It has two components:
 Default risk or default probability refers to the probability of a borrower failing to meet its
obligations to make full and timely payments of principal and interest under the terms of
the bond indenture.
 Loss severity or loss given default refers to the portion of the bond's value that an investor
would lose if a default actually occurred. Loss severity equals 1 minus the recovery rate.
 Expected loss = Default probability × Loss severity given default
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The difference in yield between a credit-risky bond and a credit-risk-
free bond of similar maturity is called its yield spread.
Spread risk refers to the risk of a widening of the yield spread on the
bond. It encompasses:
 Downgrade risk or credit migration risk: This is the risk that the issuer's
credit worthiness may deteriorate during the term of the bond, causing
rating agencies to downgrade the credit rating of the issue.
 Market liquidity risk: This is the risk that an investor may have to sell her
investment at a price lower than its market value due to insufficient
volumes (liquidity) in the market.
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LOS c: Describe seniority rankings of corporate debt and explain the potential
violation of the priority of claims in a bankruptcy proceeding.
 Priority of claims are as follows:
 First lien or first mortgage.
 Secured debt.
 Unsecured debt.
 Subordinated debt.
 In practice, holders of junior and subordinated debt and even shareholders

may recover some value on their interests without more senior creditors being
paid in full.
 A bankruptcy reorganization plan is confirmed by a vote among all classes of
investors with less than 100% recovery rate. To avoid unnecessary delays,
negotiation and compromise among various claimholders may result in a
reorganization plan that does not strictly conform to the original priority of claims.
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LOS d: Distinguish between corporate issuer credit ratings and issue
credit ratings and describe the rating agency practice of “notching.”
Issuer credit ratings, or corporate family ratings, reflect a debt issuer’s
overall creditworthiness and typically apply to a firm’s senior unsecured
debt.
Issue credit ratings, or corporate credit ratings, reflect the credit risk of
a specific debt issue.
Notching refers to the practice of adjusting an issue credit rating
upward or downward from the issuer credit rating to reflect the
seniority and other provisions of a debt issue.
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LOS e: Explain risks in relying on ratings from credit rating agencies.
Credit ratings can change during the life of a debt issue.
Rating agencies cannot always judge credit risk accurately.
Event risk difficult to assess.
Market prices of bonds often adjust more rapidly than credit ratings.
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LOS f: Explain the four Cs (Capacity, Collateral, Covenants, and
Character) of traditional credit analysis.
Capacity
Collateral
Covenants
Character
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LOS g: Calculate and interpret financial ratios used in credit analysis.
Profitability refers to operating income (EBIT) and operating profit
margin.
Cash flow may be measured as earnings before interest, taxes,
depreciation, and amortization (EBITDA); funds from operations (FFO);
free cash flow before dividends; or free cash flow after dividends.
Leverage ratios include debt-to-capital, debt-to-EBITDA, and FFO-to-
debt.
Coverage ratios include EBIT-to-interest expense and EBITDA-to-
interest expense.
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LOS h: Evaluate the credit quality of a corporate bond issuer and a bond
of that issuer, given key financial ratios of the issuer and the industry.
Lower leverage, higher interest coverage, and greater free cash flow
imply lower credit risk and a higher credit rating for a firm.
For a specific debt issue, secured collateral implies lower credit risk
compared to unsecured debt, and higher seniority implies lower credit
risk compared to lower seniority.
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LOS i: Describe factors that influence the level and volatility of yield
spreads.
yield spread = liquidity premium + credit spread
 Credit cycle.
 Economic conditions.
 Financial market performance.
 Broker-dealer capital.
 General market demand and supply.
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LOS j: Explain special considerations when evaluating the credit of high yield, sovereign,
and non-sovereign government debt issuers and issues..
 High yield bonds are more likely to default than investment grade bonds, which
increases the importance of estimating loss severity. Analysis of high yield debt
should focus on liquidity, projected financial performance, the issuer’s corporate and
debt structures, and debt covenants.
 Credit risk of sovereign debt includes the issuing country’s ability and willingness to
pay. Ability to pay is greater for debt issued in the country’s own currency than for
debt issued in a foreign currency. Willingness refers to the possibility that a country
refuses to repay its debts.
 Analysis of non-sovereign government debt is similar to analysis of sovereign debt,
focusing on the strength of the local economy and its effect on tax revenues. Analysis
of municipal revenue bonds is similar to analysis of corporate debt, focusing on the
ability of a project to generate sufficient revenue to service the bonds.
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LM: CREDIT RISK

LM: CREDIT ANALYSIS FOR GOVERNMENT

 In practice, holders of junior and subordinated debt and even shareholders

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