Fundamentals

of Credit
Analysis
Credit Ratings and
Ratings Agencies
 Different Issuers
Lowest Credit Quality Highest Credit Quality

Company W Company X Company Y Company Z

Senior Unsecured Bond Senior Unsecured Bond Senior Unsecured Bond Senior Unsecured Bond

Credit Ratings and Ratings

Agencies
 Issuer

Company X

First Lien Bond Highest Credit Quality

Senior Secured Bond

Different
Junior Secured Bond
Issues
(bonds)
Senior Unsecured Bond

Subordinated Bond Lowest

Credit
Quality

Credit Ratings and Ratings

Agencies
 Moody's S&P Fitch
Aaa AAA AAA
Aa1 AA+ AA+
Aa2 AA AA
Aa3 AA− AA−
A1 A+ A+
Investment First Lien Bond
A A
Grade A2 A− A−
Senior Secured Bond
A3
Baa1 BBB+ BBB+
Junior Secured Bond
BBB BBB
Baa2 BBB− BBB−

Non- Baa3 Senior Unsecured Bond Company X

Investment Ba1 BB+ BB+
Grade BB BB
High Yield Ba2 BB− BB−
“Junk” Subordinated Bond
Ba3
B1 B+ B+
Default B B
B2 B− B−

B3
Credit Ratings
Caa and Ratings
CCC CCC
Ca CC CC
Agencies C C C
C D D
 Moody's S&P Fitch Trigger default on the
Aaa AAA AAA
remaining issues
Aa1 AA+ AA+
Aa2 AA AA
DE
Aa3 AA− AA− FA
UL
A1 A+ A+ T
Investment First Lien Bond
A A
Grade A2 A− A− DE
FA
UL
Senior Secured Bond T
A3 DE
FA
Baa1 BBB+ BBB+ UL
T
Junior Secured Bond
BBB BBB
Baa2 BBB− BBB− DE
FA
UL
Non- Baa3 Senior Unsecured Bond T
Company X
Investment Ba1 BB+ BB+
Grade BB BB
High Yield Ba2 BB− BB−
“Junk” DE
Ba3 FA
UL
B1 B+ B+ T
Default Subordinated Bond
B B
B2 B− B−
Cross default provision triggered!
B3
Credit Ratings
Caa and Ratings
CCC CCC
Ca CC CC
Agencies C C C
C D D
 Moody's S&P Fitch
Aaa AAA AAA
Aa1 AA+ AA+
Aa2 AA AA
Aa3 AA− AA−
A1 A+ A+
Investment
A A
Grade A2 A− A−

A3
Baa1 BBB+ BBB+
BBB BBB
Baa2 BBB− BBB−

Non- Baa3
Investment Ba1 BB+ BB+
Grade BB BB
High Yield Ba2 BB− BB−
“Junk” DE
Ba3 SSJeSuneuniFoo
b
io
rio
rs
rU
rd
trSnL
eisn
cieaucnetu
re reoBdnBodBonnonddnddFAUL
rBdd
T
Default B1 B+
B
B+
B
Subordinated Bond Company X
B2 B− B−
Cross default provision triggered!
B3
Credit Ratings
Caa and Ratings
CCC CCC
Ca CC CC
Agencies C C C
C D D
Distinguish between corporate issuer credit ratings and
issue credit ratings and describe the rating agency practice
of “notching”
Issuer credit rating vs. Issue credit rating
An issuer credit rating (ICR) is a forward-looking opinion about the overall
capacity of a debt issuer, guarantor, insurer, or other provider of credit
enhancement ("obligor") to meet its financial obligations relative to other
obligors active in the financial markets.
An issue credit rating is a forward-looking opinion about the capacity of an
obligor to meet the financial commitments associated to a specific debt, bond,
lease arrangement, commercial paper, certificate of deposit, or some other
financial instrument ("obligation"), relative to the debt servicing and repayment
capacity of other obligors active in financial markets.

• Notching: A rating methodology to distinguish rating between different

liabilities of an issuer. It’s based on the idea that two securities with the
same rating should have the same expected loss rate.
 An issue may be notched down or notched up to reflect changing
risk
exposures.
 Corporate Family Rating
Company X overall creditworthiness of the company
rated on senior unsecured debt

A+ First Lien Bond Corporate Credit Rating

depends on seniority of issue and covenants

BBB+ Senior Secured Bond

assigning different ratings to bonds
Notching of the same issuer
BBB- Junior Secured Bond
Based on:
Seniority
BB- Senior Unsecured Bond
Potential loss severity
Structural subordination
CC Subordinated Bond

Credit Ratings and Ratings

Agencies
 Notching due to Structural subordination

DE
FA
UL
T
Parent Company Senior Unsecured Bond

se t
As er
n s f
tra DE
FA
UL
T
Subsidiary Senior Unsecured Bond

Assets Debt Covenant

Prohibited from transferring
assets/cash to parent before
debt is serviced

Credit Ratings and Ratings

Agencies
 Notching due to Structural subordination

DE
FA
UL
T
Parent Company Senior Unsecured Bond

se t Assets
As er
n s f
tra DE
FA
UL
T
Subsidiary Senior Unsecured Bond Priority claims on
subsidiary’s assets
Debt Covenant
Prohibited from transferring
assets/cash to parent before
debt is serviced

Credit Ratings and Ratings

Agencies
 Notching due to Structural subordination

Parent Company

Theoretically have
Senior Unsecured Bond Senior Unsecured Bond
se t the same rank
As er
n s f
tra
Subsidiary

Credit Ratings and Ratings

Agencies
 Maybe we should Notching due to Structural subordination
notch the
parent’s bond down

Parent Company

In effect, parent’s
Senior Unsecured Bond
bonds are
se t subordinated to
As er Senior Unsecured Bond
n s f subsidiary’s
tra
Subsidiary

Credit Ratings and Ratings

Agencies
 Corporate Family Rating
Company X overall creditworthiness of the company
rated on senior unsecured debt

A+ First Lien Bond Corporate Credit Rating

depends on seniority of issue and covenants

BBB+ Senior Secured Bond assigning different ratings to bonds

Notching of the same issuer
Based on:
BBB- Junior Secured Bond
Seniority
Potential loss severity
BB- Senior Unsecured Bond
Structural subordination
More common for lower-
CC Subordinated Bond rated issuers

Credit Ratings and Ratings

Agencies
 Risks in Relying on Credit Ratings

Moody's S&P Fitch

Aaa AAA AAA
Aa1 AA+ AA+
Aa2 AA AA
Aa3 AA− AA−
A1 A+ A+
A A
A2 A− A− Generally
accurate
A3
Baa1 BBB+ BBB+ measure of
Baa2 BBB BBB default
Baa3 BBB− BBB−
risk
Ba1 BB+ BB+
Ba2 BB BB
Ba3 BB− BB−
B1 B+ B+
B B
B2 B− B−

B3
Caa CCC CCC
Ca CC CC
C C C
C D D
Credit Ratings and Ratings
Agencies
 Risks in Relying on Credit Ratings
Credit Ratings are Dynamic

Moody's S&P Fitch

Aaa AAA AAA
Aa1 AA+ AA+
Aa2 AA AA
Aa3 AA− AA−
A1 A+ A+
A2 A A
A3 A− A−
Bond X Rating
Baa1 BBB+ BBB+
Baa2 BBB BBB
Baa3 BBB− BBB−
AA
Ba1 BB+ BB+
Ba2 BB BB
Ba3 BB− BB− Higher ratings ➡ More stable
B1 B+ B+
B B BB+
B2 B− B−

B3 Lower ratings ➡ Less stable

Caa CCC CCC
Ca CC CC time
C C C

C D D

Credit Ratings and Ratings

Agencies
 Risks in Relying on Credit Ratings
The credit event
Credit Ratings Lag Market Pricing happened so long
ago!

Moody's S&P Fitch

Aaa AAA AAA
Aa1 AA+ AA+ Bond X Rating
Aa2 AA AA
Aa3 AA− AA− Bond X Price
A1 A+ A+
A2 A A
A3 A− A−
Baa1 BBB+ BBB+ AA
Baa2 BBB BBB
Baa3 BBB− BBB−
Ba1 BB+ BB+
BB BB
Ba2 BB− BB− BB+
Ba3
B1 B+ B+
B2 B B
B3 B− B− time
Caa CCC CCC Credit Credit
Ca CC CC
C C C
Downgrade
C D D Event
Events such as cash flow
problems can be
predicted by studying
Credit Ratings and Ratings company’s financial
statements.
Agencies
 Risks in Relying on Credit Ratings
Event Risk is Difficult to Assess

Litigation Risk
✦ Tobacco control laws

✦ Environmental laws

Natural Disaster Risk

✦ Earthquakes, tsunamis

✦ e.g. TEPCO in 2011

Leveraged Transactions

✦ Debt-financed acquisitions

✦ Large stock buybacks

Credit Ratings and Ratings
Agencies
Explain risks in relying on ratings from credit rating agencies

Moody's S&P Fitch Egan-Jones

Credit rating agencies do a good job, but what are the risks?
• Credit ratings can (and actually do) change over time.
• Credit ratings tend to lag the market pricing of credit risk (are
reactive rather than proactive).
• Rating agencies may make mistakes.
 Examples include mis-ratings of US companies Enron and
WorldCom, and European issuer Parmalat
• Some risks are difficult to capture.
 Litigation risks, for instance, may affect tobacco or energy
or chemical companies.
 Risks in Relying on Credit Ratings
Rating Agencies are not Perfect

AAA
Su bp r i me
We make mistakes US
too! :( M BS

JUNK
GFC 2008

Credit Ratings and Ratings

Agencies