Credit Risk

Credit analysis plays a critical role in fixed-income markets. Proper evaluation and pricing of credit risk facilitates the efficient allocation of capital. This is a dynamic process as credit risk components are continuously re-evaluated and fixed-income instruments repriced according to market conditions. This learning module covers the basic principles of credit analysis. First, we introduce the concepts of credit risk and expected loss and interpret what credit ratings mean. We compare bond issuer creditworthiness within a given industry as well as across industries, and we explore how financial markets price credit risk. This lesson focuses primarily on the analysis of credit risk, while subsequent lessons discuss credit analysis of sovereign and non-sovereign government issuers as well as corporate debt

• Credit risk is the risk of economic loss resulting from borrower failure to make full and timely payments of interest and principal. The key components of credit risk are the probability of default and the loss given default, and their product is expected loss.
• Chief sources of credit risk include adverse macroeconomic conditions, a financing mismatch between resources and obligations, and issuer-specific factors in corporate and sovereign debt markets.
• Nearly every bond issue in developed debt markets carries credit ratings classifying creditworthiness. Credit ratings enable comparisons of the credit risk of debt issues and issuers within and across industries.Bonds or issuers with an investment-grade (IG) credit rating pose the lowest risk of default and are rated Baa3 by Moody’s and BBB– or higher by S&P and Fitch. In contrast, non-investment-grade or highyield (HY) bonds or issuers are rated BB+ or lower by S&P/Fitch and Ba1 or less by Moody’s and represent substantial to very high credit risk.
• Pitfalls of relying solely on credit ratings in making investment decisions include that rating agency decisions may lag market pricing of credit risk, overlook key financial risks, and/or involve miscalculations or unforeseen changes not fully captured in a rating agency’s forward-looking analysis. 
• The premium, or yield spread, at which corporate bonds trade relative to default risk-free assets widens when credit risk rises and narrows if credit risk falls.
• Credit spread changes affect holding period returns via two primary factors: a) the basis point spread change and b) the sensitivity of price to yield as reflected by end-of-period modified duration and convexity. Spread narrowing increases holding period returns.