Fundamentals of Credit Analysis | CFA Level I Fixed Income

Welcome to our exploration of credit risk, a crucial concept for anyone diving into the finance world, especially for those preparing for the CFA exams. In this lesson, we’ll dissect what credit risk entails, delve into its sources, and understand how it’s measured.

Defining Credit Risk

Credit risk is essentially the risk of losses stemming from a borrower’s failure to repay a loan or meet contractual obligations. Whether it’s the interest or the principal, if a borrower can’t pay up on time, the lender is at risk. This risk isn’t uniform; it varies based on the borrower’s specific situation and broader economic conditions.

The “C”s of Credit Analysis

Analysts often use the “C”s of credit analysis to evaluate a borrower’s creditworthiness. These include:

• Capacity: Can the borrower meet debt payments on time?
• Capital: What other resources does the company have at its disposal?
• Collateral: What assets are there to back the debt?
• Covenants: What legal terms must the borrower adhere to?
• Character: What’s the quality of the company’s management?

While capacity and capital are quantifiable, collateral, covenants, and character are more qualitative, requiring a thorough analysis of the company’s history, credit relationships, and management reputation.

Broadening the Scope

Expanding our view, three more “C”s — conditions, country, and currency — consider the larger economic and geopolitical environment that can influence all borrowers’ ability to manage their debt.

Sovereign vs. Corporate Debt

It’s vital to distinguish between sovereign and corporate debt when discussing credit risk. Sovereign entities, like governments, rely on tax revenues and other fiscal means, whereas corporations depend more on operational revenues. Each faces unique credit risk sources, from economic downturns affecting tax revenue to market changes impacting business demand.

Understanding Credit Risk Sources

For sovereign debt, risks might stem from recessions, political instability, or high foreign currency debt levels. Corporates face risks from economic downturns, increased competition, or high leverage. Recognizing these risks is crucial for both issuers looking to manage their liabilities and investors aiming to make informed decisions.

Illiquidity vs. Insolvency

It’s essential to differentiate between illiquidity and insolvency. Illiquidity is a temporary cash flow problem, whereas insolvency indicates a fundamental imbalance where liabilities exceed assets. Each has different implications for potential default and recovery strategies.

Bond Indenture Clauses

In case of default, bond indenture clauses like cross-default and pari passu become highly significant. These clauses dictate the default’s repercussions and the hierarchy of claims during liquidation, impacting the recovery prospects for different creditors.

Understanding Credit Risk Components

Credit risk, at its core, involves two critical components:

• Probability of Default (PD): This represents the likelihood that a borrower will not meet their debt obligations, whether it’s failing to pay interest or principal on time.
• Loss Given Default (LGD): This metric indicates the expected loss amount in the event of a default, after accounting for any recoveries from the sale of collateral or other means.

The expected loss is equal to the loss severity multiplied by the default risk. It can be stated as a monetary value or as a percentage of a bond’s value.

Expected Loss = Loss Severity (LGD) x Default risk (PD)

The recovery rate is the percentage of a bond’s value an investor will receive if the issuer defaults. Recovery rate is equal to one minus the loss severity in percentage terms.

Recovery Rate = 1 – Loss Severity (LGD)

Calculating Expected Loss

The expected loss can be seen as the intersection of PD and LGD, calculated as the product of the probability of default, the loss given default, and the exposure at default. This calculation offers a quantitative measure of the credit risk an investor faces.

Linking Credit Risk to Market Valuation

The intrinsic credit spread of a bond reflects the compensation investors require for bearing credit risk. By comparing the calculated credit spread based on PD and LGD with the market’s credit spread, investors can assess whether a bond is undervalued or overvalued.

Drivers of Expected Loss

The PD and LGD are influenced by various factors:

• The borrower’s financial health impacts the PD, with profitability, interest coverage, and leverage levels being key indicators.
• The nature and seniority of the debt influence the LGD, with secured debt typically experiencing lower LGD due to higher recovery rates.

Understanding these drivers helps investors and analysts evaluate the credit quality of issuers and anticipate changes in credit risk.

As we’ve explored, measuring credit risk involves a careful assessment of the probability of default and loss given default, offering valuable insights into the potential risks and rewards of fixed-income investments. This analytical approach is essential for making informed decisions and optimizing investment strategies in the context of credit risk.