Factors that are considered in the evaluation of a corporate borrower’s creditworthiness are: the quality of management; the ability of the borrower to satisfy the debt obligation; the level of seniority and the collateral available in a bankruptcy proceeding; and covenants.
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.
Credit Risk Transfer Vehicles
There are various ways that investors, particularly institutional investors, can reduce their exposure to credit risk. These arrangements are referred to as credit transfer vehicles. It should be borne in mind that an institutional investor may not necessarily want to eliminate credit risk but may want to control it or have an efficient means by which to reduce it. The increasing number of credit risk transfer vehicles has made it easier for financial institutions to reallocate large amounts of credit risk to the nonfinancial sector of the capital markets.
For a bank, the most obvious way to transfer the credit risk of a loan it has originated is to sell it to another party. The bank management’s concern when it sells corporate loans is the potential impairment of its relationship with the corporate borrower. This concern is overcome with the use of syndicated loans, because banks in the syndicate may sell their loan shares in the secondary market by means of either an assignment or a participation. With an assignment, a syndicated loan requires the approval of the obligor; that is not the case with a participation since the payments by the borrower are merely passed through to the purchaser, and therefore the obligor need not know about the sale.
Two credit risk vehicles that have increased in importance since the 1990s are securitization and credit derivatives. It is important to note that the pricing of these credit risk transfer instruments is not an easy task. Pricing becomes even more complicated for lower-quality borrowers and for credits that are backed by a pool of lower-quality assets, as recent events in the capital markets have demonstrated.
Securitization involves the pooling of loans and/or receivables and selling that pool of assets to a third-party, a special purpose vehicle (SPV). By doing so, the risks associated with that pool of assets, such as credit risk, are transferred to the SPV. In turn, the SPV obtains the funds to acquire the pool of assets by selling securities. When the pool of assets consists of consumer receivables or mortgage loans, the securities issued are referred to as asset-backed securities. When the asset pool consists of corporate loans, the securities issued are called collateralized loan obligations.
A major reason why a financial or nonfinancial corporation uses securitization as a fund-raising vehicle is that it may allow a lower funding cost than issuing secured debt. However, another important reason is that securitization is a risk management tool. Although the entity employing securitization retains some of the credit risk associated with the pool of loans (referred to as retained interest), the majority of the credit risk is transferred to the holders of the securities issued by the SPV.
A financial derivative is a contract designed to transfer some form of risk between two or more parties efficiently. When a financial derivative allows the transfer of credit exposure of an underlying asset or assets between two parties, it is referred to as a credit derivative. More specifically, credit derivatives allow investors either to acquire or to reduce credit risk exposure. Many institutional investors have portfolios that are highly sensitive to changes in the credit spread between a default-free asset and a credit-risky asset, and credit derivatives are an efficient way to manage this exposure. Conversely, other institutional investors may use credit derivatives to target specific credit exposures as a way to enhance portfolio returns. Consequently, the ability to transfer credit risk and return provides a tool for institutional–investors; the potential to improve performance. Moreover, corporate treasurers can use credit derivatives to transfer the risk associated with an increase in credit spreads (i.e., credit spread risk).
Credit derivatives include credit default swaps, asset swaps, total return swaps, credit linked notes, credit spread options, and credit spread forwards. In addition, there are index-type or basket credit products that are sponsored by banks that link the payoff to the investor to a portfolio of credits. Credit derivatives are over-the-counter instruments and are therefore not traded on an organized exchange. Hence, credit derivatives expose an investor to counterparty risk, and this has been the major concern in recent years in view of the credit problems of large banks and dealer firms who are the counterparties.
Credit derivatives also permit banks to transfer credit risk without the need to transfer assets physically. For example, in a collateral loan obligation, a bank can sell a pool of corporate loans to a special purpose vehicle (SPV) in order to reduce its exposure to the corporate borrowers. Alternatively, it can transfer the credit risk exposure by buying credit protection for the same pool of corporate loans. In this case, the transaction is referred to as a synthetic collateralized loan obligation.
An understanding of credit derivatives is critical even for those who do not want to use them. As Alan Greenspan, then the Chairman of the Federal Reserve Board, in a speech on September 25, 2002, stated:
“The growing prominence of the market for credit derivatives is attributable not only to its ability to disperse risk but also to the information it contributes to enhanced risk management by banks and other financial intermediaries. Credit default swaps, for example, are priced to reflect the probability of net loss from the default of an ever broadening array of borrowers, both financial and non-financial.”2
A credit-linked note (CLN) is a security, usually issued by an investment-grade-rated corporation, that has an interest payment and fixed maturity structure similar to a standard bond. In contrast to a standard bond, the performance of the CLN is linked to the performance of a specified underlying asset or assets as well as that of the issuing entity. There are different ways that a CLN can be credit linked, and we will describe one case here.
British Telecom issued on December 15, 2000, a CLN with a coupon rate of 8.125% maturing on December 15, 2010. The terms of this CLN stated that the coupon rate would increase by 25 basis points for each one-notch rating downgrade of British Telecom below A–/A3 suffered during the life of the CLN. The coupon rate would decrease by 25 basis points for each rating upgrade, with a minimum coupon set at 8.125%. In other words, this CLN allows investors to make a credit play based on this issuer’s credit rating. In fact, in May 2003, British Telecom was downgraded by one rating notch and the coupon rate was increased to 8.375%.
While market participants typically think of credit risk in terms of the failure of a borrower to make timely interest and principal payments on a debt obligation, this is only one form of credit risk: credit default risk. The other types of credit risk are credit spread risk and downgrade risk. When evaluating the credit default risk of a borrower, credit analysts look at 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 covenants. Credit risk transfer vehicles include securitization and credit derivatives. Credit derivatives include credit default swaps, asset swaps, total return swaps, credit linked notes, credit spread options, credit spread forwards, and baskets or indexes of credits.
Making It Happen
1 Moody’s Investor Service. “Industrial company rating methodology.” Global Credit Research (July 2008): 6.
2 Speech titled “World Finance and Risk Management,” at Lancaster House, London, United Kingdom.