(A)

Bottom-up credit analysis factors are as follows:

● Capacity. The borrower’s ability to make their debt payments on time.

● Capital. Other resources available to the borrower that reduce reliance on debt.
● Collateral. The value of assets pledged to provide the lender with security in the
event of default.
● Covenants. The legal terms and conditions the borrowers and lenders agree to as
part of a bond issue.
● Character. The borrower’s integrity (e.g., management for a corporate bond) and
their commitment to make payments under their debt obligations.

Secured corporate debt is backed primarily by the operating cash lows and investments of
the business plus cash lows generated from collateral specifically pledged as security for
the debt.

Unsecured corporate debt is only backed by the operating cash lows and investments of
the issuer (as well as secondary sources of cash low such as asset sales, divestures of
subsidiaries, or additional debt/equity issuance)

Sovereign debt is backed by tax revenue, tariffs, and other fees charged by the government
issuer. Secondary sources of cash low include additional debt issuance and sale of public
assets (privatizations).

Credit analysts should distinguish between an issuer being illiquid, or unable to raise cash
to service debt, and being insolvent, where the assets of an issuer fall below the value of its
debt. An illiquid issuer may not necessarily be insolvent, but could still default

A cross default clause means that a default on one bond issue causes a default on all
issues. A pari passu clause means all bonds of a certain type rank equally in the default
process

Credit risk is measured by assessing the expected loss from a debt investment in
the event of default:
Expected loss = probability of default × loss given default

Probability of default is the probability that a borrower fails to pay interest or repay
principal when due. The probability is typically expressed on an annualized basis.
Loss given default is the loss an investor will suffer if the issuer defaults. This can be
stated as a monetary amount or as a percentage. Loss given default, stated as a percentage,
is the product of the expected exposure and the loss severity:

LGD% = expected exposure × (1 - recovery rate)

A bond’s expected recovery rate is the proportion of a claim an investor will recover if the
issuer defaults. The proportion an investor will not recover, or one minus the recovery rate,
is known as loss severity.

A debt investor’s expectedexposure or exposure at default is the difference between the

amount the investor is owed (principal and accrued interest) and the value of the collateral
available to repay the investor.

Credit spread ≈ probability of default × LGD%

If the actual credit spread of the issue is higher than this estimated credit spread, the
investor is more than fairly compensated for the credit risk of the investment. If the
actual credit spread of a bond is less than this estimated credit spread, investors are
not adequately compensated for credit risk and should avoid investing

Probability of default can be assessed through quantitative metrics relating to

capacity to repay. For example, a profitable company with high EBIT margin, a high
interest coverage ratio (EBIT/interest), low leverage multiples (e.g., debt/EBITDA), and a
high ratio of cash low to net debt would be deemed of high credit quality (low probability of
default)

(B)

Due to their financial strength, investment grade issuers have lower probability of default
than high-yield issuers. However, high-yield issuers often issue secured debt with a
secondary source of repayment in the event of default. As a result, high-yield debt can have
lower losses given default than unsecured bonds of an investment grade issuer. The
greatest risk to the investors in unsecured investment grade debt is not an increase in loss
given default, but an increase in the probability of default due to deterioration in the
issuer’s inancial situation.
Credit Migration Risk, the risk that a credit rating downgrade will decrease the value of
the bonds and potentially trigger other contractual clauses.

Triple A (AAA or Aaa) is the highest rating. Bonds with ratings of Baa3/BBB- or higher
are considered investment grade. Bonds rated Ba1/BB+ or lower are considered
non-investment grade and are often called high-yield bonds or junk bonds

Relying on ratings from credit rating agencies has some risks:

1. Credit ratings lag market pricing

2. Some risks are difficult to assess. Risks such as litigation, natural disasters,
environmental risks, acquisitions, and equity buybacks using debt are not easily
predicted, or captured in credit ratings. Agencies may take different views on the
likelihood of such events, leading to split ratings where the same debt issue gets
assigned different ratings from different agencies.

3. Rating agencies are not perfect. Mistakes occur from time to time.

Credit spread risk is the risk that yield spreads widen due to deteriorating conditions,
causing credit-risky bond prices to decrease. This is a primary concern for investment
grade bond investors because default is unlikely to occur suddenly. A more realistic concern
is that spreads widen and prices fall as credit conditions worsen. Credit spread risk arises
from macroeconomic, issuer-specific, and market (trading related) factors.

High-yield spreads can widen dramatically in times of crisis as investors sell riskier assets
and buy safer ones in a flight to quality.

Incentives for exposure to this higher credit spread risk include the following:

● Diversification. High-yield bond prices have low or even negative correlation with
investment grade bonds, so they can diversify a fixed-income portfolio.
● Capital Appreciation. The larger spread changes for high-yield issues produce
larger price gains during economic recoveries compared to investment grade issues.
● Equity-like returns. According to some empirical data, high-yield debt offers
equity-like returns with lower volatility than equity markets.

Market liquidity risk relates to the transaction costs of trading a bond. It can be assessed
through analyzing the bid–offer spreads of market makers in a bond. The bid is the price at
which investors can sell bonds, while the offer is the price at which investors can buy. A
wider bid–offer spread implies higher costs of trading to investors and indicates higher
market liquidity risk. Market liquidity risk is higher for less actively traded bonds, for
issuers with lower credit quality, and for issuers with less debt outstanding in bond
markets

(C)

Each different type of bond of a particular issuer is ranked according to a priority of claims
in the event of a default. A bond’s position in the priority of claims to the issuer’s assets and
cash lows is referred to as its seniority ranking. Debt can be either secured debt
or unsecured debt. Secured debt is backed by collateral, which can be sold to recover
funds for bond investors in the event of default by the issuer. Unsecured debt represents a
general claim to the issuer’s assets and cash lows. Secured debt has a higher priority of
claims than unsecured debt.

Secured debt can be further distinguished as first lien (where a specific asset is pledged)
or first mortgage (where a specific property is pledged), senior secured (second lien), or
junior secured debt. Unsecured debt is further divided into senior, junior, and
subordinated gradations. The highest rank of unsecured debt is senior unsecured.
Subordinated debt ranks below other unsecured debt. The general seniority rankings for
debt repayment priority are the following:

1. First lien/mortgage
2. Senior secured (second lien)
3. Junior secured
4. Senior unsecured
5. Senior subordinated
6. Subordinated
7. Junior subordinated

Credit rating agencies rate both the issuer (i.e., the company issuing the bonds) and the
debt issues, or the bonds themselves. Issuer credit ratings are called corporate family
ratings (CFRs), and are typically based on their senior unsecured debt, while
issue-specific ratings are called corporatecredit ratings (CCRs). The ratings of a
firm’s individual bonds can differ from its corporate (issuer) rating. The seniority and
covenants (including collateral pledged) of an individual bond issue are the primary
determinants of differences between an issuer’s rating and the ratings of its individual
bond issues.