Fundamentals of Credit Analysis

Credit Risk
 Credit Risk
risk associated with
losses incurred by
Lenders
from the
failure of a

Borrower
to make timely and
full payments of
Principal
Coupon
BOND

Bondholder Bond Issuer

Credit
Risk
corporate bonds

What is credit risk?

• The risk of loss resulting from the borrower (issuer of debt) failing
to make full and timely payments of interest and/or principal.
• Has two components:

Default risk Loss given default (LGD)

Probability that the
The portion of a
borrower fails to
bond’s value
meet its obligation
(including unpaid
to make full and Credit risk
interest) an
timely payments of
investor
principal and
loses.
interest

Expected loss = Default probability × Loss given default

 Credit Risk

Loss Severity Default Risk

losses incurred by the failure of a
Lenders Borrower

Principal
Coupon
BOND

Credit
Risk
 I wonder
how much Recovery Rate
I can’t pay.
my % of bond’s value I have to
loss is!
=1-
default!
Expected Loss = %Loss Severity x Default Risk
$ amount estimate of the value the probability that a
% of bond’s value lender may lose if the borrower fails to pay
borrower defaults interest or repay
$ amount principal when due
% of bond’s value

Principal
Coupon
BOND

Lenders Borrower
Credit
Risk
 I wonder
how much my
loss is! I can’t pay.
I have to

default!
70%
Recovery Rate
$ amount estimate of the value the probability
% of bond’s value
that a
% of bond’s value
= 1lender
- may lose if the borrower fails to
pay
borrower defaults =
Expected Loss Loss Severityinterestxor repay
Default Risk

0.3%
$ amount
30% 1%
principal when due
% of bond’s value

Principal
Coupon
BOND

Credit
Lenders Risk
Risks related to credit risk

Spread risk: The gap between a debt

instrument’s yield and the yield of default-free
government bonds may widen.

Credit downgrade risk: A bond issuer’s

creditworthiness may deteriorate, resulting
in higher risk of default.

Market liquidity risk: The price at which

investors can transact (buying or selling) may
differ from the price indicated in the market.
 Credit Risk

Yield for risky bond

2-yr corporate bond

Similar maturity 6.0%

Yield for risk-free bond Spread 350bp

2-yr Treasury Note 2.5%
time
0

Credit
Risk
 Credit Risk

%/
$
Bond Price
inversely related to spreads

Yield for risky bond

Similar maturity
Yield for risk-free bond Spread Spread

Bench
mark
time
0

Credit
Risk
 Market Liquidity Risk ↓Creditworthiness Credit Migration Risk Downgrade
➡ ↑Market Liquidity Risk risk
Receiving less than ↑Spread due to
market value due to wider ↓Issue size ↓Creditworthiness
bid-ask spreads ➡ ↑Market Liquidity Risk
Creditworthiness of
Lenders Borrower
Liquidity of markets Credit
Risk
Spread Premium
Liquidity

Premium
Benchmark
↓Liquidity ➡ ↑Spread

Credit
Risk
 Market Liquidity Risk Spread Risk Credit Migration Risk Downgrade
risk
Receiving less than ↑ Spread ↑Spread due to
market value due to wider due to ↓Creditworthiness
bid-ask spreads ↑Credit Migration Risk
and/or Creditworthiness of
↑Market Liquidity Risk
Lenders Borrower
Liquidity of markets Credit
Risk
Spread Premium
Liquidity

Premium
Benchmark

Credit
Risk