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Financing Best Practice

Minimizing Credit Risk

by Frank J. Fabozzi

Executive Summary

Introduction

Financial corporations and investors face several types of risk. One major risk is credit risk. Despite the fact that market participants typically refer to “credit risk” as if it is one-dimensional, there are actually three forms of this risk: credit default risk, credit spread risk, and downgrade risk.

Credit default risk is the risk that the issuer will fail to satisfy the terms of the obligation with respect to the timely payment of interest and repayment of the amount borrowed. This form of credit risk covers counterparty risk in a trade or derivative transaction where the counterparty fails to satisfy its obligation. To gauge credit default risk, investors typically rely on credit ratings. A credit rating is a formal opinion given by a company referred to as a rating agency of the credit default risk faced by investing in a particular issue of debt securities. For long-term debt obligations, a credit rating is a forward-looking assessment of the probability of default and the relative magnitude of the loss should a default occur. For short-term debt obligations, a credit rating is a forward-looking assessment of the probability of default. The nationally recognized rating agencies include Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings.

Credit spread risk is the loss or underperformance of an issue or issues due to an increase in the credit spread. The credit spread is the compensation sought by investors for accepting the credit default risk of an issue or issuer. The credit spread varies with market conditions and the credit rating of the issue or issuer. On the issuer side, credit spread risk is the risk that an issuer’s credit spread will increase when it must come to market to offer bonds, resulting in a higher funding cost.

Downgrade risk is the risk that an issue or issuer will be downgraded, resulting in an increase in the credit spread demanded by the market. Hence, downgrade risk is related to credit spread risk. Occasionally, the ability of an issuer to make interest and principal payments diminishes seriously and unexpectedly because of an unforeseen event. This can include any number of idiosyncratic events that are specific to the corporation or to an industry, including a natural or industrial accident, a regulatory change, a takeover or corporate restructuring, or corporate fraud. This risk is referred to generically as event risk and will result in a downgrading of the issuer by the rating agencies.

Factors Considered in Assessing Credit Default Risk

The most obvious way to protect against credit risk is to analyze the creditworthiness of the borrower. In performing such an analysis, credit analysts evaluate the factors that affect the business risk of a borrower. These factors can be classified into four general categories—the quality of the borrower; the ability of the borrower to satisfy the debt obligation; the level of seniority and the collateral available in a bankruptcy proceeding; and restrictions imposed on the borrower.

In the case of a corporation, the quality of the borrower involves assessing the firm’s business strategies and management policies. More specifically, a credit analyst will study the corporation’s strategic plan, accounting control systems, and financial philosophy regarding the use of debt. In assigning a credit rating, Moody’s states:

“Although difficult to quantify, management quality is one of the most important factors supporting an issuer’s credit strength. When the unexpected occurs, it is a management’s ability to react appropriately that will sustain the company’s performance.”1

The ability of the borrower to meet its obligations begins with the analysis of the borrower’s financial statements. Commonly used measures of liquidity and debt coverage combined with estimates of future cash flows are calculated and investigated if there are concerns. In addition, the analysis considers industry trends, the borrower’s basic operating and competitive position, sources of liquidity (backup lines of credit), and, if applicable, the regulatory environment. An investigation of industry trends aids a credit analyst in assessing the vulnerability of the firm to economic cycles, the barriers to entry, and the exposure of the company to technological changes. An investigation of the borrower’s various lines of business aids the credit analyst in assessing the firm’s basic operating position.

A credit analyst will look at the position as a creditor in the case of a bankruptcy. The US Bankruptcy Act comprises 15 chapters, each covering a particular type of bankruptcy. Of particular interest here are Chapter 7, which deals with the liquidation of a company, and Chapter 11, which deals with the reorganization of a company. When a company is liquidated, creditors receive distributions based on the absolute priority rule to the extent that assets are available. The absolute priority rule is the principle that senior creditors are paid in full before junior creditors are paid anything. For secured creditors and unsecured creditors, the absolute priority rule guarantees their seniority to equity holders. However, in the case of a reorganization, the absolute priority rule rarely holds because in practice unsecured creditors do in fact typically receive distributions for the entire amount of their claim and common stockholders may receive something, while secured creditors may receive only a portion of their claim. The reason is that a reorganization requires the approval of all the parties. Consequently, secured creditors are willing to negotiate with both unsecured creditors and stockholders in order to obtain approval of the plan of reorganization.

The restrictions imposed on the borrower (management) that are part of the terms and conditions of the lending or bond agreement are called covenants. Covenants deal with limitations and restrictions on the borrower’s activities. Affirmative covenants call on the debtor to make promises to do certain things. Negative covenants are those that require the borrower not to take certain actions. A violation of any covenant may provide a meaningful early warning alarm, enabling lenders to take positive and corrective action before the situation deteriorates further. Covenants play an important part in minimizing risk to creditors.

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Further reading

Books:

  • Anson, Mark J. P., Frank J. Fabozzi, Moorad Choudhry, and Ren-Raw Chen. Credit Derivatives: Instruments, Pricing, and Applications. Hoboken, NJ: Wiley, 2004.
  • Fabozzi, Frank J., Moorad Choudhry, and Steven V. Mann. Measuring and Controlling Interest Rate and Credit Risk. 2nd ed. Hoboken, NJ: Wiley, 2003.

Articles:

  • Fabozzi, Frank J., and Moorad Choudhry. “Originating collateralized debt obligations for balance sheet management.” Journal of Structured Finance 9:3 (Fall 2003): 32–52. Online at: dx.doi.org/10.3905/jsf.2003.320318
  • Fabozzi, Frank J., Henry A. Davis, and Moorad Choudhry, “Credit-linked notes: A product primer.” Journal of Structured Finance 12:4 (Winter 2007): 67–77. Online at: dx.doi.org/10.3905/jsf.12.4.67
  • Lucas, Douglas J., Laurie S. Goodman, and Frank J. Fabozzi. “Collateralized debt obligations and credit risk transfer.” Journal of Financial Transformation 20 (2007): 47–59. Online at: tinyurl.com/24t4qbd [PDF].

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