This topic review introduces credit analysis, primarily for corporate bonds, but
considerations for credit analysis of high yield, sovereign, and non-sovereign
government bonds are also covered. Focus on credit ratings, credit spreads, and the
impact on return when ratings and spreads change.
LOS 55.a: Describe credit risk and credit-related risks affecting corporate bonds.
LOS 55.b: Describe default probability and loss severity as components of credit risk.
CFA
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Study Session 16
Program Curriculum, Volume 5, page 592
Credit risk is the risk associated with losses stemming from the failure of a borrower to
make timely and full payments of interest or principal. Credit risk has two components:
default risk and loss severity.
Default risk is the probability that a borrower (bond issuer) fails to pay interest
or repay principal when due.
Loss severity, or loss given default, refers to the value a bond investor will lose if
the issuer defaults. Loss severity can be stated as a monetary amount or as a
percentage of a bond’s value (principal and unpaid interest).
The expected loss is equal to the default risk multiplied by the loss severity. Expected
loss can likewise be stated as a monetary value or as a percentage of a bond’s value.
The recovery rate is the percentage of a bond’s value an investor will receive if the
issuer defaults. Loss severity as a percentage is equal to one minus the recovery rate.
Bonds with credit risk trade at higher yields than bonds thought to be free of credit
risk. The difference in yield between a credit-risky bond and a credit-risk-free bond of
similar maturity is called its yield spread. For example, if a 5-year corporate bond is
trading at a spread of +250 basis points to Treasuries and the yield on 5-year Treasury
notes is 4.0%, the yield on the corporate bond is 4.0% + 2.5% = 6.5%.
Bond prices are inversely related to spreads; a wider spread implies a lower bond price
and a narrower spread implies a higher price. The size of the spread reflects the
creditworthiness of the issuer and the liquidity of the market for its bonds. Spread risk
is the possibility that a bond’s spread will widen due to one or both of these factors.
Credit migration risk or downgrade risk is the possibility that spreads will
increase because the issuer has become less creditworthy. As we will see later in
this topic review, credit rating agencies assign ratings to bonds and issuers, and
may upgrade or downgrade these ratings over time.
Market liquidity risk is the risk of receiving less than market value when selling a
bond and is reflected in the size of the bid-ask spreads. Market liquidity risk is
greater for the bonds of less creditworthy issuers and for the bonds of smaller
issuers with relatively little publicly traded debt.
LOS 55.c: Describe seniority rankings of corporate debt and explain the potential
violation of the priority of claims in a bankruptcy proceeding.
CFA
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Program Curriculum, Volume 5, page 595
Each category of debt from the same issuer is ranked according to a priority of claims
in the event of a default. A bond’s priority of claims to the issuer’s assets and cash
flows is referred to as its seniority ranking.
Debt can be either secured debt or unsecured debt. Secured debt is backed by
collateral, while unsecured debt or debentures represent a general claim to the issuer’s
assets and cash flows. Secured debt has higher priority of claims than unsecured debt.
Secured debt can be further distinguished as first lien or first mortgage (where a
specific asset is pledged), senior secured, or junior secured debt. Unsecured debt is
further divided into senior, junior, and subordinated gradations. The highest rank of
unsecured debt is senior unsecured. Subordinated debt ranks below other unsecured
debt.
The general seniority rankings for debt repayment priority are the following:
First lien or first mortgage.
Senior secured debt.
Junior secured debt.
Senior unsecured debt.
Senior subordinated debt.
Subordinated debt.
Junior subordinated debt.
All debt within the same category is said to rank pari passu, or have same priority of
claims. All senior secured debt holders, for example, are treated alike in a corporate
bankruptcy.
Recovery rates are highest for debt with the highest priority of claims and decrease
with each lower rank of seniority. The lower the seniority ranking of a bond, the higher
its credit risk. Investors require a higher yield to accept a lower seniority ranking.
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