Understanding Credit Risk

Credit risk arises when there is a potential for a borrower to default on their obligations, specifically by failing to fulfill their interest and principal payment obligations on a bond or loan. This particular risk, which originates from a contractual relationship, presents a significant performance risk that investors in fixed-income securities must effectively manage. The size of its impact is influenced not just by borrower-specific circumstances but also by the wider economic context.

Traditional Credit Analysis – The “Cs”

In order to assess the creditworthiness of a borrower, analysts commonly utilize a set of metrics known as the “Cs”. The five criteria below pertain to the detailed, individual-level factors relevant to a specific borrower, also known as bottom-up factors.

1. Capacity: Assesses the borrower’s ability to make debt payments in a timely manner.
2. Capital: This metric indicates the extent of available resources that the borrower may rely on, hence lowering their reliance on debt.
3. Collateral: The assets that serve as a foundation for the borrower’s indebtedness.
4. Covenants: Legally binding obligations that the borrower is obligated to adhere to.
5. Character: A qualitative metric used to evaluate the quality of management and their willingness to fulfill their financial obligations.

Broader Economic Influences on Credit Risk (Top-Down Factors)

In addition to the above borrower-specific measures, credit risk is influenced by three broad aspects.

1. Conditions: Encompasses the current economic and business environment.
2. Country: Considers geopolitical intricacies alongside the legal and political framework of the borrower’s jurisdiction.
3. Currency: Examines the implications of fluctuations in exchange rates or liabilities denominated in foreign currency.

Sources of Repayment for Different Bonds

Corporations primarily rely on business operations, investment, and financing activities for repayment, while secondary sources include asset sales, divestitures, and additional debt issuances. The associated credit risks encompass economic contraction, strategic market shifts, heightened competition, and diminished pricing power. In contrast, sovereign or public entities derive their main repayment from corporate and personal taxes and from issuing new debt, with risks tied to shrinking operating margins and escalating losses.

A borrower might be illiquid, meaning they cannot access funds to make a payment, which differs from being insolvent, where the borrower’s liabilities surpass their assets.

Components of Credit Risk

Probability of Default (POD)

This metric gauges the likelihood of a borrower not meeting payment obligations fully and on time. A combination of lower profitability, lower coverage (e.g., EBIT to interest expense), and increased leverage suggests a higher POD, indicating lower credit quality for corporate issuers.

Loss Given Default (LGD)

The concept of LGD pertains to the possible financial loss that an investor may experience in the event of a default. LGD is calculated by multiplying the Exposure at Default (EE) by the complement of the Recovery Rate (RR).

\[LGD = EE \times (1 – RR)\]

Where:

• EE (Expected Exposure) is the expected claim at default, typically the loan or bond face value plus accrued interest minus the current collateral’s market value.
• RR (Recovery Rate) represents the percentage of the debt claim recovered upon default.

Expected Loss (EL)

The expected loss (EL) is a function of both POD and LGD and is expressed as:

\[EL = POD \times LGD\]

Investors assess their compensation for credit risk by comparing the expected loss to the credit spread over a given period. The credit spread, which signifies the additional yield a risky bond offers over a risk-free rate, serves as a metric for the reward an investor anticipates for bearing credit risk. Investors are deemed fairly compensated if the credit spread aligns with the expected loss.

The relationship between credit spread and expected loss can be approximated as:

\[Credit\ Spread\ \approx POD \times LGD\]

The risk of expected loss for investment-grade debt is primarily due to a rise in POD. High-yield investors seek covenant restrictions and/or security to lower LGD.

Example: Credit Spread

An investor reviews ClearSky Enterprises’ unsecured debt and finds a POD of 3% and an LGD of 75%. With an actual credit spread of 250 bps per year, the investor would expect to be more than fairly compensated for assuming ClearSky Enterprises’ credit risk. This is determined as follows:

\[POD \times LGD = 0.03 \times 0.75 = 2.25\%\]

Credit Spread \(>\) POD \(\times\) LGD. Thus, the investor would anticipate being more than adequately compensated for bearing ClearSky’s credit risk.

Question

For a sovereign or public entity, which of the following is most likely a primary source of repayment?

1. Business operations
2. Corporate and personal taxes
3. Asset sales

The correct answer is B.

Sovereign or public entities primarily derive their repayment from corporate and personal taxes.

A is incorrect. Business operations are a primary source of repayment for corporations, not sovereign entities.

C is incorrect. Asset sales are a secondary source of repayment for corporations, not a primary source for sovereign entities.