Fin431x (Ch 20&21) 1

Credit Rating and Credit Risk Modeling

1. Major components of corporate bond credit analysis

2. Business risk

3. Corporate Governance Risk

4. Financial Risks

5. Alternative credit risk models

Fin431x (Ch 20&21) 2

Overview of Credit AnalysisAnalysis of Covenant

Analysis of Collateral

Analysis of Issuer’s Ability to Pay

•Business risk

•Corporate governance risk

•Financial risk

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Analysis of Business Risk

• Business risk is the risk associated with operating cash flows, such as industry trends, operating environment, profitability, competition

Fin431x (Ch 20&21) 4

Corporate Governance Risk

Ownership structure of the corporation

See four key elements evaluated by S&P on page 452.

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Financial Risk

• Interest rate coverage ratio: measuring the number of times interest charges are covered on a pretax basis. One is defined as EBITDA/interest expenses. See page 454.

• Leverage ratio – example is the ratio of total debt to EBITDA for a trailing 12-month period

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Financial RiskCash flow: see alternative cash flow measures on

page 455: company with a high percentage of assets in cash and marketable securities is in a much stronger position than a company whose primary assets are illiquid real estate.

Net assets: may refer to liquidation value of a firmWorking capital: the stronger the companies

liquidity measure, the better it can weather a downturn in business and reduction in cash flow. – should look at different items as well.

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Case

Lear Corp. (LEA)

A high-yield bond

http://www.lear.com/index.jsp

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Credit Risk Modeling

Credit risk models are used to measure, monitor, and control a portfolio’s credit risk.

Difficulties:

1. Credit default is a rare event

2. Types of borrowers vary widely

Fin431x (Ch 20&21) 9

Structural Models

Originated from option pricing models where common stockholders can be viewed as having a call option on the value of the assets with the right being granted by the bondholders

BSM – page 497.

The option is triggered when the firm defaults

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Reduced-form Models

Treating default as an exogenous event

Model it with a Poisson process

Jarrow-turnbull Model

Duffie-Singleton Model

Fin431x (Ch 20&21) 11

Exercises

1. Question 4, chapter 20