Executive Summary
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Credit risk encompasses credit default risk, credit spread risk, and downgrade risk.
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Market participants typically gauge credit default risk in terms of the credit rating assigned by rating agencies.
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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.
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Credit risk transfer vehicles allow the redistribution of credit risk.
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Securitization is a credit risk transfer vehicle for corporations that is accomplished by selling a pool of loans or receivables to a third-party entity.
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Credit derivatives are a form of credit risk transfer vehicle.
Introduction
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.
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