Credit Risk

Credit risk is a risk that arrises from the possibility of the borrower failing to pay any scheduled interest or principal payment on its debt on time. It depends on the probability of default and the expected loss to the debtholder if default occurs. A debt with higher credit risk has higher yield and lower price and vice versa.

Credit risk is a function of default risk and the expected loss if default is certain. Default risk is the risk that a default will occur and expected loss equals the total amount of the outstanding debt minus the amount that can be recovered.

$$\text{Credit Risk}=\text{Default Risk}\times \text{LGD}$$

$$\text{Credit Risk}=\text{Default Risk}\times \text{N}\times(\text{1}-\text{rr})$$

Where LGS stands for loss given default which equals the product of N and (1 - rr). N is the total amount outstanding and rr is the recovery rate, the percentage of total amount that is expected to be recovered.

Credit spread is the premium that a debt must pay over and above the yield on a default-free debt of the same maturity as compensation for credit risk. It equals yield on a bond minus the yield on government bonds of the same maturity as the debt minus the associated liquidity premium. The relationship can be expressed mathematically as follows:

$$\text{Credit Spread}=\text{Bond Yield}\ -\ \text{Treasury Yield}\ -\ \text{Liquidity Premium}$$

Four Cs

Credit risk of a particular debt issue can be different than the overall credit risk of the issuer. The credit risk of a debt depends on a lot of factors including the company’s industry, the company’s corporate structure (whether a subsidiary or a holding company), whether the debt is secured, its ranking with reference to other debt, the business cycle, etc.

The 4Cs framework is a good starting point for subjective assessment of credit risk. It involves assesses character, capacity, capital and collateral. Character represents the company’s credit history, the reputation of its management, its brand value, etc.; capacity represents the ability to take on additional debt as measured by the company’s times interest earned ratio, debt to EBITDA ratio, etc.; capital represents how much equity capital the company is contributing to the project for which it has raised debt, i.e. its capital structure; and collateral represents the quality of security available i.e. the security such as mortgage, pledge, etc. on which the lender can fall back in case of default.

Credit Ratings

Credit Ratings are grades assigned by the three major credit ratings agencies i.e. Standard & Poor’s, Moody’s and Fitch to different corporate debt representing the perceived credit risk of the debt. Ratings are more concerned with the probability of default and less with the severity of loss if default occurs.

The ratings range from AAA or Aaa at the lowest credit-risk end to C or D at the highest credit risk end. Bonds rated Baa3/BBB- or higher are referred to as investment grade debts while bonds with a rating of Ba1/BB+ or lower is termed below investment grade (also called speculative-grade/high-yield or junk debt).

Bondholders experience a risk associated with ratings upgrade or downgrade called the downgrade risk. Downgrade risk is the that risk that the yield on the company’s debt will increase and consequently its price will fall due to a downgrade in the debt rating. Downgrade risk is also called credit migration risk.