At the end of this session you should be able to:
- understand what is meant by credit risk
- understand the role of the credit rating agencies
- differentiate between credit ratings
- understand strengths of credit ratings
What is a credit risk?
Credit risk is, broadly speaking, the risk that the borrower is unable to fulfil its financial obligations. From an investor’s perspective the debtor (borrower or issuer) has two principal obligations:
- To pay interest when it's due.
- To repay principal when it's due.
The primary question in fixed income credit analysis is whether the issuer of a debt security can service its debt in a timely manner over the life of a given bond or loan.
Generally, credit risk is greater for securities with a long maturity as there is a longer period for the issuer to potentially default or encounter difficulties.
Different debt owners or creditors within a corporate structure have different rights of repayment should a company go into liquidation. Compared to other obligations of a company, bonds are considered a relatively low risk asset as:
- they usually represent a legal commitment to make interest and principal payments
- bonds (excluding perpetuals) have a maturity date at which time investors receive all principal and the final interest payment
- in the event of a company going into liquidation, bond holders are senior to all hybrid holders and equity holders in the creditors’ queue – however they may be subordinate to secured creditors