CHAPTER 10

Credit Analysis Models

Saïd Boukendour, PhD.

Part-time professor
Fall 2022

© 2020 CFA Institute. All rights reserved.

CONTENTS
1 Introduction
2 Modeling Credit Risk and Credit Valuation Adjustment
3 Credit Scores and Credit Ratings
4 Structural and Reduced-Form Credit Models
5 Valuing Risky Bonds in an Arbitrage-Free Framework
6 Interpreting Changes in Credit Spreads
7 The Term Structure of Credit Spreads
8 Credit Analysis for Securitized Debt
9 Summary

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© 2020 CFA Institute. All rights reserved.
 1. INTRODUCTION
CREDIT ANALYSIS MODELS
• This chapter covers important concepts, tools, and
applications of credit analysis.
• Topics include:
- Modeling credit risk
- Credit scoring and ratings
- Structural and reduced-form models
- Valuing risky bonds using the arbitrage-free framework
- Credit spreads
- Securitized debt

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 2. MODELING CREDIT RISK AND
THE CREDIT VALUATION ADJUSTMENT
• The credit risk on a bond can be measured by:

The credit spread, which captures credit risk as

the difference between the yields-to-maturity on
a corporate bond and a government bond.

The credit valuation adjustment (CVA), which

measures credit risk in present value terms as a
percentage of par value.

• Both measures depend on the expected exposure, the loss

given default, and the probability of default.

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 DETERMINANTS OF CREDIT RISK
Expected exposure
• The projected amount the investor could lose if an
event of default occurs, before considering recovery.

Recovery Rate and Loss Given Default (LGD)

• The recovery rate is the percentage of the loss that is
recovered. The LGD is amount of the loss if default
occurs, after considering recovery.

Probability of Default
• The probability that a bond issuer will not meet its
contractual interest and principal obligations on
schedule.

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 CREDIT RISK CALCULATION EXAMPLE

An analyst believes that the credit risk on a 3-year, 8% annual

payment corporate bond can be expressed by an annual
probability of default 2% and a recovery rate of 35%. Given that
the government yield curve is flat at 3%, calculate the credit
spread and credit valuation adjustment for the bond.

This table summarizes the preliminary results, the calculations are

shown on the following slides.

Expected PV of Expected
Date Exposure Recovery LGD POD POS Loss DF Loss
0
0.97087
1 117.5673 41.1486 76.4188 2.0000% 98.0000% 1.5284 4 1.4839
0.94259
2 112.8544 39.4990 73.3553 1.9600% 96.0400% 1.4378 6 1.3552
0.91514
3 108.0000 37.8000 70.2000 1.9208% 94.1192% 1.3484 2 1.2340
5.8808% 4.0731

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 EXPECTED EXPOSURE, RECOVERY, AND THE
LOSS GIVEN DEFAULT (LGD)

• The exposures to default loss on Dates 1 and 2 are 117.5673 and

112.8544.
= 112.8544

• The recovery for Date 1 is 41.1486 (= 117.5673 x 0.35).

The LGD is 76.4188 = (117.5673 – 41.1486).

• The recovery for Date 2 is 39.4990 (= 112.8544 x 0.35).

The LGD is 73.3553 (= 112.8544 – 39.4990).

• The exposure at maturity on Date 3 is 108, the final coupon plus

the par value. The recovery is 37.8 (= 108 x 0.35) and the LGD
70.2 (= 108 – 37.8).

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 PROBABILITY OF DEFAULT (POD) AND
PROBABILITY OF SURVIVAL (POS)

• This credit risk model assumes conditional default probabilities–

the probability of default assuming no prior default.

• By assumption the probability of default on Date 1 is 2% and the

probability of survival into the second year is 98%.

• The conditional probability of default on Date 2 is 1.96% (= 2% x

98%) and the probability of survival in the third year is 96.04%
(= 98% – 1.96%).

• The POD for Date 3 is 1.9208% (= 2% x 96.04%) and the POS is

94.1192% (= 96.04% – 1.9208%).

• As of Date 0, the probability of default on this bond at some time

is 5.8808%. Note that 5.8808% + 94.1192% = 100%.
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 EXPECTED LOSS, DISCOUNT FACTOR (DF), AND
PV OF EXPECTED LOSS
• The expected loss on each date is the loss given default times
the conditional probability of default.
76.4188 × 2.0000% = 1.5284
73.3553 × 1.9600% = 1.4378
70.2000 × 1.9208% = 1.3484

• The present value (PV) of the expected loss is the expected

losses times the government bond discount factors:
1.5284 × 0.970874 (= 1/1.031) = 1.4839
1.4378 × 0.942596 (= 1/1.032) = 1.3552
1.3484 × 0.915142 (= 1/1.033) = 1.2340

• The sum of the PVs of expected losses (4.0731) is the credit

valuation adjustment (CVA).

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 CREDIT VALUATION ADJUSTMENT AND CREDIT
SPREAD
• The price of a hypothetical 3-year, 8% annual payment
government bond given a yield-to-maturity of 3% would be
114.1431 (per 100 of par value).
+ + = 114.1431

• The fair value of the risky corporate bond is 110.0700, the value
of the hypothetical government bond less the CVA.
114.1431 – 4.0371 = 110.0700

• The yield-to-maturity on the corporate bond is 4.3473%, the

solution for yield.
110.0700 = + +

• The credit spread is 1.3473% (= 4.3473% - 3%), or 134.73 basis

points.

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 3. CREDIT SCORES AND CREDIT RATINGS

• Credit scores are used primarily in retail lending markets

for small businesses and individuals.
• Credit scores are national in scope because scoring
methodologies differ by country.
Example: FICO scores in the U.S. that are based on consumer
credit files collected by national credit bureaus.

Primary factors determining a FICO score are payment history,

debt burden, length of credit history, types of credit used, and
recent credit inquiries.

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 CREDIT RATINGS

• Credit ratings are used in wholesale markets for bonds

issued by corporations, government entities, and for asset-
backed securities.
- Examples: Moody’s, Standard & Poor’s, and Fitch.
- These agencies provide both issuer and issue “letter
grade” ratings and a positive, stable, or negative
outlook.
- Issuer ratings are usually for senior unsecured debt.
- “Notching” is an adjustment for issue ratings to reflect
priority of claim and subordination.

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 CREDIT RATING MIGRATION TABLE

The credit rating agencies provide transition matrices

based on historical data. This is a representative
example for one-year transitions and credit spreads on
10-year corporate bonds.
From/To AAA AA A BBB BB B CCC,CC,C D
AAA 90.00 9.00 0.60 0.15 0.10 0.10 0.05 0.00
AA 1.50 88.00 9.50 0.75 0.15 0.05 0.03 0.02
A 0.05 2.50 87.50 8.40 0.75 0.60 0.12 0.08
BBB 0.02 0.30 4.80 85.50 6.95 1.75 0.45 0.23
BB 0.01 0.06 0.30 7.75 79.50 8.75 2.38 1.25
B 0.00 0.05 0.15 1.40 9.15 76.60 8.45 4.20
CCC,CC,C 0.00 0.01 0.12 0.87 1.65 18.50 49.25 29.60
Credit Spread 0.60% 0.90% 1.10% 1.50% 3.40% 6.50% 9.50%  

A corporate bond having a AA rating has a 88% chance

of remaining AA, a 1.50% chance be being upgraded to
AAA, and a 9.50% chance of being downgraded to A.

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 CALCULATING EXPECTED RETURN

Based on the Credit Migration Table and the Credit Spreads, the
expected one-year return on a 10-year corporate bond that is currently
rated BBB and that has a modified duration of 7.0 is the yield-to-maturity
minus 1.64%. For each possible transition, the expected percentage
price change is:
- From BBB to AAA: – 7.0 × (0.60% – 1.50%) = + 6.30%
- From BBB to AA: – 7.0 × (0.90% – 1.50%) = + 4.20%
- From BBB to A: – 7.0 × (1.10% – 1.50%) = + 2.80%
- From BBB to BB: – 7.0 × (3.40% – 1.50%) = – 13.30%
- From BBB to B: – 7.0 × (6.50% – 1.50%) = – 35.00%
- From BBB to CCC,CC,C – 7.0 × (9.50% – 1.50%) = – 56.00%
The probabilities in the transition matrix give the expected change:
(0.0002 × 6.30%) + (0.0030 × 4.20%) + (0.0480 × 2.80%) + (0.8550 × 0%)
+ (0.0695 × – 13.30%) + (0.0175 × – 35.00%) + (0.0045 × – 56.00%) = – 1.64%

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 4. STRUCTURAL AND REDUCED-FORM CREDIT MODELS

Structural credit risk models are based on the idea that a company
defaults on its debt when the value of its assets is less than its liabilities
and the probability of that default event has the features of an option.

Equity can be interpreted as a purchased call option on

-. company assets with a strike price of the debt’s face value

Debt holders in this model own the assets and write the
call option

The premium on the call option can be interpreted as the

value of priority of claim in event of bankruptcy.

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 STRUCTURAL CREDIT MODELS

Strengths of Structural Models

- Provide insight into why a company defaults on debt.
- Option pricing models are well-developed in finance theory and practice and
are used by credit rating agencies.
- Can be used for internal risk management by the company (and its
commercial bankers)

Weakness of Structural Models

- Assumes that the assets of the company trade and have observable prices
- Can be difficult to implement in practice due to data unavailability or
unreliability, especially during times of financial crisis.

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 REDUCED-FORM CREDIT MODELS

Reduced-form credit risk models assume that the probability is an

default is an exogenous variable and that the event of default occurs
randomly.

The time of default can be modeled using a Poisson

stochastic process.

The key parameter is the default intensity, which is the

probability of default over the next time increment.

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 REDUCED-FORM CREDIT MODELS
Strengths of Reduced-Form Models
- Implementation relies on observable inputs, including historical data.
- Default intensity is estimated using regression analysis on company-
specific and macroeconomic variables.
- Require only information generally available in financial markets.
- Can be used to value risky debt securities and credit derivatives.

Weakness of Reduced-Form Models

- Does not explain the economic reasons for default, which comes as
a “surprise” in the model.
- In reality, corporate default is rarely a “surprise” as seen by the usual
pattern of credit rating downgrades.

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 5. VALUING RISKY BONDS
IN AN ARBITRAGE-FREE FRAMEWORK
A 3-year, 3.50% fixed-rate corporate bond would have a value of
105.8869 if it were default free (VND).
Date 0 Date 1 Date 2 Date 3

99.8046 103.5
3.7026%

101.6533 3.5
1.9442%

105.8869 3.5 100.4547 103.5

- 0.2500% 3.0315%

102.5910 3.5
1.5918%
100.9933 103.5
2.4820%

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 ARBITRAGE-FREE RISKY BOND VALUATION EXAMPLE

• Assuming an annual probability of default of 1.75% and a recovery

rate of 30%, the CVA is 3.6991.
Expected Discount
Date Exposure LGD POD Factor CVA/DVA
0
1 105.6222 73.9355 1.7500% 1.002506 1.2971
2 103.9269 72.7488 1.7194% 0.985093 1.2322
3 103.5000 72.4500 1.6893% 0.955848 1.1699
5.1587% 3.6991

• The fair value for the risky corporate bond is 102.1877, the VND
of 105.8869 minus the CVA of 3.6991.

• Given the coupon rate of 3.50% and three years to maturity, the
yield-to-maturity is 2.7306%.

• The credit spread over the 3-year benchmark bond yield of 1.50%
is 1.2306%.
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 ARBITRAGE-FREE RISKY BOND VALUATION EXAMPLE

A 3-year floating-rate note paying the 1-year reference rate plus

1.00% has a VND of 102.9434.

Date 0 Date 1 Date 2 Date 3

100.9643 104.7026
3.7026%

101.9299 2.9442
1.9442%

102.9434 0.7500 100.9706 104.0315

- 0.2500% 3.0315%

101.9423 2.5918
1.5918%
100.9758 103.4820
2.4820%

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 ARBITRAGE-FREE RISKY BOND VALUATION EXAMPLE

• Assuming an annual probability of default of 1.50% and a recovery

rate of 50%, the CVA is 2.2508.
Expected Discount
Date Exposure LGD POD Factor CVA/DVA
0
1 102.6861 51.3430 1.5000% 1.002506 0.7721
2 103.7383 51.8692 1.4775% 0.985093 0.7549
3 104.0619 52.0310 1.4553% 0.955848 0.7238
4.4328% 2.2508

• The fair value for the risky floating-rate note is 100.6926, the VND
of 102.9434 minus the CVA of 2.2508.

• Because the floater is priced at a premium, the quoted margin of

1.00% is greater than the discount margin.

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 6. INTERPRETING CHANGES IN CREDIT SPREADS

A corporate bond yield can be

decomposed into:

1. The spread over the

benchmark yield on a
government bond. This
captures microeconomic
factors (expected loss from
default, liquidity, taxation).

2. The benchmark yield on a

maturity-matching government
bond. This captures
macroeconomic factors
(expected inflation and the real
rate of interest).

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 NARROWING CREDIT SPREADS

• A fixed-income analyst observes that the credit spread on a corporate bond

narrows from 155 basis points (1.55%) to 142 basis points (1.42%).

Which factors can explain this event?

(a) Investors believe the probability of default has gone up

(b) Investors believe the probability of default has gone down
(c) Investors believe the recovery rate has gone up
(d) Investors believe the recovery rate has gone down
(e) Investors have become more risk averse
(f) Investors have become less risk averse

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 WIDENING CREDIT SPREADS

• A fixed-income analyst observes that the credit spread on a corporate bond

widens from 155 basis points (1.55%) to 168 basis points (1.68%).

Which factors can explain this event?

(a) Investors believe the probability of default has gone up

(b) Investors believe the probability of default has gone down
(c) Investors believe the recovery rate has gone up
(d) Investors believe the recovery rate has gone down
(e) Investors have become more risk averse
(f) Investors have become less risk averse

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 7. TERM STRUCTURE OF CREDIT SPREADS

The credit spread term structure (the credit curve) displays the
relationship between credit spreads over benchmark yields and time-to-
maturity. It has many uses:
- Issuers (and their underwriters) use the credit curve to set terms on
a new issuance.
- Investors use the credit curve to determine bids on new issuances.
- Central banks use the credit curve to supplement yield curves on
benchmark debt to set monetary policy.

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 DETERMINANTS OF TERM STRUCTURE
OF CREDIT SPREADS

Credit quality
o High quality bonds—credit spread term structure tends to be flat
or slightly upward sloping
o Lower quality bonds--term structure tends to be more steeply
sloped

Financial conditions
o Economic strengthening—higher benchmark yields and narrower
credit spreads
o Economic weakening—lower benchmark yields and wider credit
spreads
o Credit spreads and benchmark yield tend to be countercyclical
over the business cycle

Market demand and supply

o In general, the credit curve may steepen when issuers replace
short-term (maturing) debt with new long-term debt

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 DETERMINANTS OF TERM STRUCTURE
OF CREDIT SPREADS (CONTINUED)

Changes in market expectations of default

o A high quality issuer having low leverage, strong cash flow,
strong competitive position, and a high profit margin will have a
very low credit spread over short-term maturities.
o But macroeconomic uncertainty can lead to higher default
probabilities for longer times-to-maturity, giving an upwardly
sloped credit curve.

Inverted credit curves

o A leveraged or private equity buyout of a high-yield firm can lead
lower default probabilities for longer times-to-maturity as leverage
improves and efficiencies are introduced.
o Bonds of distressed firms may be trading at their recovery values
leading to the appearance of a lower probability of default on
longer-maturity debt but the result may be only “optical”.

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 8. CREDIT ANALYSIS FOR SECURITIZED DEBT

Compared to general obligation corporate bonds, credit analysis

of structured debt requires:

Detailed analysis of the prospective cash flow, default and

recovery characteristics for a specific set of assets or
receivables rather than a firm’s entire balance sheet

An understanding of the parties associated with the origination

of and servicing of the securitized asset portfolio over the life of
the issuance and how that portfolio might change over time, and

A thorough review of the issuing entity as well as structural and

credit enhancement features for a specific tranche or tranches
of debt which are typically present in these transactions.

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 CREDIT ANALYSIS FOR SECURITIZED DEBT
Assets in securitized debt differ by:

• Homogeneity—homogeneous assets are those with similar

characteristics and eligibility criteria such as credit card and
auto loans which may be assessed on a portfolio basis, while
heterogenous assets (commercial real estate and project
finance loans) should be assessed on a loan-by-loan basis

• Granularity—the size and number of assets within a given

securitized debt portfolio relative to the overall portfolio.
Homogeneous assets tend to be granular, meaning that a
portfolio may consist of hundreds of loans with very similar
characteristics, while heterogeneous portfolios consist of fewer
larger loans which require a loan-by-loan credit analysis.

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 STRUCTURAL ENHANCEMENTS FOR SECURITIZED DEBT

• Bankruptcy remoteness – the extent to which the structured debt is

related to the originator. Typically, the assets are transferred to a
special purpose entity (SPE) to create legal separation.

• Credit enhancements include:

• Payout or performance triggers in case of adverse credit events
• Overcollateralization (referred to as excess spread), and/or
• Subordinated tranches which absorb initial portfolio losses

• Covered bonds – Senior debt obligations of financial institution which

offer dual recourse, namely recourse to the originator/issuer and to a
predetermined underlying collateral pool.

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 9. SUMMARY
Three factors important to modeling credit risk
• The three factors are: expected exposure to default, recovery rate,
and the loss given default.
• These factors permit the calculation of a credit valuation adjustment
that is subtracted from the (hypothetical) value of the bond, if it were
default risk free, to get the bond’s fair value given its credit risk. The
credit valuation adjustment is calculated as the sum of the present
values of the expected loss for each period in the remaining life of
the bond.
• The CVA captures investors’ compensation for bearing default risk.
The compensation can also be expressed in terms of a credit
spread.

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© 2020 CFA Institute. All rights reserved.
 SUMMARY
Credit scores and credit ratings

• Credit scores and credit ratings are third-party evaluations of

creditworthiness used in distinct markets.
• Analysts may use credit ratings and a transition matrix of
probabilities to adjust a bond’s yield-to-maturity to reflect the
probabilities of credit migration. Credit spread migration typically
reduces expected return.

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© 2020 CFA Institute. All rights reserved.
 SUMMARY
Credit analysis models
• Credit analysis models fall into two broad categories: structural
models and reduced-form models.
• Structural models are based on an option perspective of the
positions of the stakeholders of the company. Bondholders are
viewed as owning the assets of the company; shareholders have
call options on those assets.
• Reduced-form models seek to predict when a default may occur,
but they do not explain the why as do structural models. Reduced-
form models, unlike structural models, are based only on
observable variables.

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© 2020 CFA Institute. All rights reserved.
 SUMMARY
Arbitrage-free valuation
• When interest rates are assumed to be volatile, the credit risk of a
bond can be estimated in an arbitrage-free valuation framework.
• The discount margin for floating-rate notes is similar to the credit
spread for fixed-coupon bonds. The discount margin can also be
calculated using an arbitrage-free valuation framework.
• Arbitrage-free valuation can be applied to judge the sensitivity of the
credit spread to changes in credit risk parameters.

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© 2020 CFA Institute. All rights reserved.
 SUMMARY
Credit spread curve
• The term structure of credit spreads depends on macro and micro
factors.
• As it concerns macro factors, the credit spread curve tends to
become steeper and widen in conditions of weak economic activity.
Market supply and demand dynamics are important. The most
frequently traded securities tend to determine the shape of this
curve.
• Issuer- or industry-specific factors, such as the chance of a future
leverage-decreasing event, can cause the credit spread curve to
flatten or invert.

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© 2020 CFA Institute. All rights reserved.
 SUMMARY
Credit risk
• When a bond is very likely to default, it often trades close to its
recovery value at various maturities; moreover, the credit spread
curve is less informative about the relationship between credit risk
and maturity.
• For securitized debt, the characteristics of the asset portfolio
themselves suggest the best approach for a credit analyst to take
when deciding among investments. Important considerations
include the relative concentration of assets and their similarity or
heterogeneity as it concerns credit risk.

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© 2020 CFA Institute. All rights reserved.