Session 6 - Credit Risk

At the end of this session you should be able to:

1. understand what is meant by credit risk
2. understand the role of the credit rating agencies
3. differentiate between credit ratings
4. 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:

1. To pay interest when it's due.
2. 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

Analysing creditworthiness of debt issuers is a complex task. FIIG has a specialist Research Department devoted to analysing risks associated with bond issuers from a fixed income perspective, as debt and equity investors’ interests are often different. What may be negative for equity holders can be a positive development for bondholders. For example, a cut in dividend is negative from a shareholder’s perspective (and for a large company this will be widely reported in the media), but it means the company is retaining cash within the business, ultimately supporting bond holders by providing additional subordination.

Ratings agencies monitor whether an issuer pays its financial obligations in full and on time. Many individuals have been late once or twice in a mortgage or car payment, or a credit card bill has been skipped. If a rated issuer missed a loan repayment the credit rating agencies would deem it as a default on the loan and the issuer’s credit rating would be downgraded.

Governments, companies and structured issuers try to protect their credit ratings as the credit rating largely drives the price they must pay to borrow. The highest rated entities pay the lowest risk premium on their debt. Those that are rated sub-investment grade must pay more to borrow and in some cases very low rated companies cannot borrow at all.

Who are the rating agencies?

Governments, companies and structured issuers try to protect their credit ratings as the credit rating largely drives the price they must pay to borrow. The highest rated entities pay the lowest risk premium on their debt. Those that are rated sub-investment grade must pay more to borrow and in some cases very low rated companies cannot borrow at all.

The rating process

For the purpose of this explanation, S&P’s ratings definitions will be used and the basis of that rating will be reviewed. As would be expected, the rating is based on the likelihood of the company defaulting on its debt obligations. S&P refer to this as the capacity and willingness of the borrower to make timely payment of interest and repayment of principal.

Credit rating agency models are both quantitative, based on historical and forecast financial results and qualitative, that is without numerical basis. Qualitative measures are subject to interpretation, so there is room for judgment in the credit rating process.

Any credit analysis will need to take into account the nature of the organisation that is issuing the bond. For example, a bond issued by a government body (such as the Queensland Treasury Corporation) is usually guaranteed by the underlying state government.

Importantly, analysis of a company’s bonds by a potential bond investor will require different criteria to analyse the company’s shares by a potential shareholder.

When an investor considers buying shares in a company they may assess factors like the earnings per share (EPS) or the dividend yield, the price/earnings ratio (PE) or the price to NTA (net tangible assets). The investor will make an assessment of the growth prospects for the company and the quality of the management. They will try to decide if the company is in an industry that will provide further growth potential and examine the company’s competitive position within the industry.

A debt (bond) investor will look at different factors such as the company’s cash flow position, overall level of gearing and interest coverage ratios as well as factors such as the quality of management and the nature of the industry in which the firm operates. Often key in the assessment is the company’s debt maturity profile and the likelihood of the company obtaining finance to repay debt as and when it comes due.

The primary question in bond credit analysis is whether the firm has the ability to meet its commitment to pay all debts (both principal and interest) in full and on time. Remember that a company does not have to report a profit to make coupon payments, but they do have to manage cashflows as coupon payments are contractual payments that the company must make.

The other factor to keep in the back of your mind is that a company exists for the benefit of its shareholders. It is in the interests of the firm to portray themselves as being less risky than they are. The lower the rate they pay for finance, the less reward you as a bondholder receive.

Generally, for a company to pay a dividend to its shareholders, it must have paid the coupon on all its debt, which sits higher in the capital structure (see Figure 6.1 below).

In simple terms the rating agencies examine the factors mentioned above to assess the capacity of the company (the issuer of the debt) to pay the money back and pay it back in full and on time.

They then examine the nature and the provisions of the actual obligation (bond) they are rating. There may be factors or elements in the documentation of the obligation or something else within the structure of the debt that may make it less creditworthy. The third thing they will look at is the protection afforded by the obligation, i.e. the relative position of the obligation. Here the rating agencies examine the level of seniority of the issue, that is, its exact position in the capital structure of the company. The more senior it is, the more secure it is. For the same company, a lower ranked asset may have a lower credit rating indicating higher risk.

The ratings scale

The following table describes the ratings scale used by the three major ratings agencies.

The ratings agencies offer further information on the relative standing of issuers by adding extra scale to the ratings AA (Aa) to CCC (Caa). S&P and Fitch use a plus (+) and minus (-) sign and Moody’s use the numbers 1, 2 & 3 for this purpose. Table 6.5 below outlines the complete range of possible investment grade ratings as issued by the three major rating agencies.

Generally an investment grade rating (BBB- or Baa3 or better) indicates a low expected risk of default. As the credit improves through investment grade levels the risk falls even further, to an almost negligible level by the time you reach AAA.

Short term ratings

The rating agencies also give short term ratings for debts issued for less than one year. A company may well have a stronger short term rating than a long term rating. Generally a sound financial company may be in an industry that’s in long term decline or highly volatile. Such a company may justify having a relatively high short term rating, but not such a strong long term rating given its industry.

Three primary investment grade ratings in the short term used by S&P are A-1, which is a strong capacity to meet financial commitments, A-2, which is a satisfactory capacity to meet financial commitments, and A-3, which is an adequate capacity to meet financial commitments. There is also an A-1+ category for the very strongest of the A-1 issuers. The Moody’s terminology for this is P-1, P-2 and P-3, and Fitch uses F1+, F1, F2 and F3.

Issuer ratings and issue ratings

It is important to note that a company’s credit rating may not be the same as the credit rating on one of the securities issued by that company. There are a number of reasons why a company’s rating may be different to that of one of its issues. Normally, when a company is rated, it is rated at the senior unsecured level, so the debt that is being rated is senior, though unsecured, debt. It is possible to increase the rating on a security by securing the issue against a particular cash flow or asset. This may however have the effect of reducing the creditworthiness of the rest of the company.

By securing its debt against a particular asset, a company may lift the credit quality of a portion of its debt. It does this by placing those creditors (the owners of that bond) in front of all the other creditors in the event of liquidation of the company for access to that particular asset or the cash flows from that asset. Likewise, the rating may be lower than that for the company and this is the case where companies issue subordinated debt.

It may also be possible for an issuer to issue higher rated securities which are ‘wrapped’ by an insurer. A wrapped bond is a security issued by a company and then insured by a third party, most commonly an insurance company, which provides a guarantee to the investors that if the underlying issuer fails to pay principal or interest that the insurer or wrapper will make such payments. Such bonds usually attempt to enhance the credit rating of the issuer thereby reducing the cost of borrowing for the issuer.

Creditor's priority queue

The list below provides an abridged version of a creditors’ queue in the liquidation of a company. It gives an idea of the ranking and the order of payment of the various claimants on a company should it go into liquidation. The senior secured creditors rank highest of the debt holders, particularly with reference to the assets over which they have security. Next are the ordinary debt and other unsecured creditors, followed by the subordinated debt holders, with preference shares and share capital (equity) at the bottom of the list. Understanding that ranking and bearing in mind that each of those in the list gets paid in full before the next category gets paid anything, gives an idea of the extra risk that is being assumed by taking another step down the creditors’ queue.

Whilst each hybrid issue will specify its own terms the majority will rank as preference shares in the case of liquidation.

Credit spreads

This example outlines the credit premiums available to the various credit ratings on five year bonds as at the 14 February 2011. Five year Commonwealth bonds were trading at 5.50%. As the credit quality of the issue deteriorates, the risk premium charged by the market increases.

The Commonwealth of Australia is rated AAA, as are most of the state governments. Major Australian banks are rated AA. All three issuer groups have a very strong capacity to repay principal and interest when due, however, the return on bonds varies. An investor might earn an additional 50-150 basis points of yield over and above Commonwealth Government securities (CGL) for bank debt. This additional yield is generally accepted as being partly a liquidity premium and partly a credit premium. As the credit quality moves down the ratings scale the additional return increases. As at 14 February 2011, Telstra bonds were trading 1.60% over the Commonwealth Government yield of 5.40% and Stockland 2.50% over.

Conclusion

You should now understand what is meant by credit risk, the role of the credit rating agencies and generally how rating agencies measure and report credit risk. You should be able to differentiate between the ratings and understand the scales of the various ratings agencies.

Review questions

1.  Which of the following does not influence the level of credit risk a bond may possess at any one time?

1. The time to maturity or duration
2. The face value of the bond
3. The level of subordination
4. The issuer’s ability to refinance

2.  One of the factors that a ratings agency must consider when rating the level of risk of a bond is capital structure. That is, the level of seniority of the issue and where exactly the bond sits in regard to the capital structure of the company. Out of the following types of securities, which offers the lowest risk in terms of capital structure?

1. Hybrids
2. Senior secured debt
3. Senior debt
4. Subordinated debt

3. Why would a cut in a dividend be beneficial to bondholders?

1. It allows the company to retain cash within the business
2. It provides additional subordination to bondholders which sit higher in the capital structure
3. It reduces the equity price and makes bonds more attractive
4. All of the above
5. Both a and b