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Credit Risk is Different than Equity Risk



Credit Analysis – Goals

The goal of credit analysis is to assess an issuer’s ability to satisfy its debt obligations, which in this case means a deliberate focus on the issuer’s ability to generate enough cash flows to cover its debt payments.[1] That's a little more cash flow centric than some equity analysis. Why is that?

Because Credit Analysis is different than Equity Analysis

Management has a fiduciary duty to maximize shareholder wealth. Their only duty to credit holders, however, is to meet their legal obligations as spelled out in the bond indentures/covenants.

Thus credit analysis is more focused on measuring the stability of cash flows and the degree of downside risk (recovery rates etc), while equity analysis is more focused on the strategies that will raise earnings and company value over time. One caveat to this is that analyzing whether to buy a junk bond may share more similarities to equity analysis. This is because a junk bond shares characteristics of both bonds (cash flows) and equities (bet on share price appreciation).

If that's not clear enough, sometimes it can help to focus on the definition of credit risk itself.

(Also, while the CFA Exam, and especially Level 1, love to ask this compare-contrast question, the definition and measurement of credit risk are equally testable. So pay attention!)  

Defining Credit Risk on the CFA Exam

As you know, credit risk is the risk of a borrower failing to make timely or full payments. The higher the credit risk the higher the required yield or the higher the spread between a bond and its benchmark.

Credit risk has two facets—default risk and loss severity. 

  • Default risk – Is the probability that a borrower fails to pay interest or repay principal in a timely manner
  • Loss severity – Is the actual amount a bond investor will lose in the event of a default. It can be given either as a dollar amount or as a percentage and is equal to (1- recovery rate)
  • Recovery rate – The % of a bond’s value an investor recovers in case of default.

 Finally, and most importantly:

 Expected Loss = Default risk x Loss severity

Interpreting the Recovery Rate

Recovery rates can fluctuate across industries and business cycles. Regardless of cycle, however, recovery rates are the highest for the senior-most class of debt. Therefore, the lower the seniority of debt, the higher the credit risk, and the higher the required yield. All debt in the same class is pari passu, meaning it has the same priority on claims.

Seniority of Debt

Here’s the order of seniority of claims. We think this specific information is less likely to be tested on the CFA L1 exam vs. the CFA L2/3 exams:

  • First lien or first mortgage (pledge on specific asset)
  • Senior secured debt
  • Junior secured debt
  • Senior unsecured debt
  • Senior subordinated debt
  • Subordinated debt
  • Junior subordinated debt

For more, and especially if you are a CFA Level 3 exam candidate, we recommend you now jump to our post on both credit risk and its measurement via credit spreads. 

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[1] Willingness is a secondary consideration since debt contracts are legally enforceable