Fundamentals of

Credit Analysis
Credit Risk
 Credit Risk
risk associated with
losses incurred by
Lenders
from the failure of a

Borrower
to make timely and
full payments of

Principal
Coupon
BOND

Bondholder Bond Issuer

Credit Risk
 Credit Risk

Loss Severity Default Risk

losses incurred by the failure of a
Lenders Borrower

Principal
Coupon
BOND

Credit Risk
 I wonder
how much my Recovery Rate
I can’t pay.
loss is! % of bond’s value I have to
=1- default!

Expected Loss = %Loss Severity x Default Risk

$ amount estimate of the value the
% of bond’s value lender may lose if the
borrower defaults
$ amount
% of bond’s value
probability that a
borrower fails to pay
interest or repay
principal when due

Principal
Coupon
BOND

Lenders Borrower
Credit Risk
 I wonder
how much my
I can’t pay.
loss is!
I have to
default!
70%
%
Recovery Rate
$ amount estimate of the value the probability that a
lender %
may of bond’s
lose if the value
borrower fails to pay
% of bond’s value
=1-
borrower defaults interest or repay
$ amount principal when due
=bond’s
Expected Loss % of Loss Severity
value x Default Risk
0.3% 30%
Principal 1%
Coupon
BOND

Lenders Borrower
Credit Risk
 Credit Risk

Yield for risky bond

2-yr corporate bond

Similar maturity 6.0%

Yield for risk-free bond Spread 350bp

2-yr Treasury Note 2.5%
time
0

Credit Risk
 Credit Risk

%/$

Bond Price
inversely related to spreads

Yield for risky bond

Similar maturity

Yield for risk-free bond Spread Spread

Bench
mark
time
0

Credit Risk
 Market Liquidity Risk ↓Creditworthiness Credit Migration Risk Downgrade
➡ ↑Market Liquidity Risk risk
Receiving less than ↑Spread due to
market value due to wider ↓Issue size ↓Creditworthiness
bid-ask spreads ➡ ↑Market Liquidity Risk
Creditworthiness of
Lenders Borrower
Liquidity of markets Credit
Risk
Spread Premium
Liquidity
Premium

Benchmark
↓Liquidity ➡ ↑Spread

Credit Risk
 Market Liquidity Risk Spread Risk Credit Migration Risk Downgrade
risk
Receiving less than ↑Spread ↑Spread due to
market value due to wider due to ↓Creditworthiness
bid-ask spreads ↑Credit Migration Risk
and/or Creditworthiness of
↑Market Liquidity Risk
Lenders Borrower
Liquidity of markets Credit
Risk
Spread Premium
Liquidity
Premium

Benchmark

Credit Risk
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