FIN30021 Fixed Income and Debts Markets Question 1 Week - 5 Module 5 Explain whether you agree or disagree with the following statement: "The credit risk of a bond is the risk that the issuer will fail to meet its obligations to make timely payment interest and principal" Credit risk is more general than the statement in the quote. Credit risk encompasses three types of risk: default risk, credit spread risk and downgrade risk. The quote in the question refers to default risk only. Credit risk spread is the risk that the credit spread will increase. Downgrade risk is the risk that the issue will be downgraded. Question 2 In addition to credit ratings, what other information is provided by rating agencies that investors can use to gauge the credit risk of an issuer? Information in addition to the credit rating that is provided by the rating agency includes rating watches, rating outlooks and transition tables. The first two are useful in assessing default risk while the last is useful for assessing downgrade risk. When an issue is put on rating watch, this means that the rating agency is reviewing the issue with the potential for an upgrade or a downgrade. A rating outlook is a projection of whether an issue in the long term (from 6 months to two years) likely to be upgraded (positive outlook) downgraded (negative outlook) or maintain its current rating (stable outlook) Question 3 How do long-term credit ratings differ from short-term credit ratings? A credit rating is a forward-looking assessment of credit risk. For long-term debt obligations, it is an assessment of (1) the probability of default and (2) the relative magnitude of the loss should a default occur. For short term debt obligations, a credit rating is an assessment of only the probability of default.
Question 4 Why is the analysis of covenants important in credit analysis? Since covenants deal with limitations and restrictions on the borrower's activities certain covenants provide protection for a bondholder and this protection must be factored into the credit analysis. Egs - restrictions on future debt; debt but not higher order; selling assets; dividend payment to shareholders Question 5 What is a negative covenant? A negative covenant is one that requires the borrower not to take certain actions. An example of a negative covenant is a restriction on the company's ability to incur additional debt. Question 6 What is the notching process? distinguish between corporate issuer credit ratings and issue credit ratings and describe the rating agency practice of "notching"; Valuations often adjust before ratings change, and the notching process may not adequately reflect the price decline of a bond that is lower ranked in the capital structure. Because ratings primarily reflect the probability of default but not necessarily the severity of loss given default, bonds with the same rating may have significantly different expected losses (default probability times loss severity). And like analysts, credit rating agencies may have difficulty forecasting certain credit-negative outcomes, such as adverse litigation,