CHAPTER 2
23
Types of Credit Risk
n Chapter 1 we discussed the three types of credit risk: credit default risk, credit spread risk, and downgrade risk. Credit default risk is the risk that the issuer will fail to satisfy the terms of the obligation with respect to the timely payment of interest and repayment of the amount borrowed. To gauge the default risk, investors rely on analysis per- formed by nationally recognized statistical rating organizations that perform credit analysis of issues and issuers and express their conclu- sions in the form of a credit rating. Credit spread risk is the loss or underperformance of an issue or issues due to an increase in the credit spread. Downgrade risk is the risk that an issue or issuer will be down- graded, resulting in an increase in the credit spread. In this chapter we take a closer look at each type of credit risk.
the issuer before the bonds are placed. Credit assessments take time, however, and also require the specialist skills of credit analysts. Large institutional investors do in fact employ such specialists to carry out credit analysis; however, often it is too costly and time-consuming to assess every issuer in every debt market. Therefore investors commonly employ two other methods when making a decision on the credit default risk of debt securities: name recognition and formal credit ratings.
Name recognition is when the investor relies on the good name and reputation of the issuer and accepts that the issuer is of such good financial standing, or sufficient financial standing, that a default on interest and principal payments is highly unlikely. An investor may feel this way about say, Microsoft or British Petroleum plc.
However the experience of Barings in 1995 suggested to many inves- tors that it may not be wise to rely on name recognition alone in today’s marketplace. The tradition and reputation behind the Barings name allowed the bank to borrow at LIBOR or occasionally at sub- LIBOR interest rates in the money markets, which put it on a par with the highest-quality banks in terms of credit rating. However name recognition needs to be augmented by other methods to reduce the risk against unforeseen events, as happened with Barings.
A credit rating is a formal opinion given by a rating agency of the credit default risk faced by investing in a particular issue of debt securi- ties. For long-term debt obligations, a credit rating is a forward-looking assessment of the probability of default and the relative magnitude of the loss should a default occur. For short-term debt obligations, a credit rating is a forward-looking assessment of the probability of default.
Credit ratings are provided by specialist companies referred to as rat- ing agencies. They include Moody’s Investors Service, Standard & Poor’s Corporation, and Fitch Ratings. On receipt of a formal request, the rating agencies will carry out a rating exercise on a specific issue of debt capital.
The request for a rating comes from the organization planning the issu- ance of bonds. Although ratings are provided for the benefit of investors, the issuer must bear the cost. However, it is in the issuer’s interest to request a rating as it raises the profile of the bonds, and investors may refuse to buy a bond that is not accompanied with a recognized rating.
Although the rating exercise involves credit analysis of the issuer, the rating is applied to a specific debt issue. This means that in theory the credit rating is applied not to an organization itself, but to specific debt securities that the organization has issued or is planning to issue. In prac- tice it is common for the market to refer to the creditworthiness of orga- nizations themselves in terms of the rating of their debt. A highly rated company, for example, may be referred to as a “triple-A rated” company, although it is the company’s debt issues that are rated as triple A.
The rating systems of the rating agencies use similar symbols. Sepa- rate categories are used by each rating agency for short-term debt (with original maturity of 12 months or less) and long-term debt (over one year original maturity). Exhibit 2.1 shows the long-term debt ratings. In all rating systems the term “high grade” means low credit risk or, conversely, high probability of future payments. The highest-grade bonds are desig- nated by Moody’s by the letters Aaa, and by the others as AAA. The next highest grade is Aa (Moody’s), and by the others as AA; for the third grade all rating agencies use A. The next three grades are Baa (Moody’s) or BBB, Ba (Moody’s) or BB, and B, respectively. There are also C grades.
S&P and Fitch use plus or minus signs to provide a narrower credit qual- ity breakdown within each class. Moody’s uses 1, 2, or 3 for the same purpose. Bonds rated triple A (AAA or Aaa) are said to be “prime”; dou- ble A (AA or Aa) are of high quality; single A issues are called “upper medium grade”; and triple B are “medium grade.” Lower-rated bonds are said to have “speculative” elements or be” distinctly speculative.”
Bond issues that are assigned a rating in the top four categories are referred to as investment-grade bonds. Bond issues that carry a rating below the top four categories are referred to as noninvestment grade bonds or more popularly as high-yield bonds or junk bonds. Thus, the bond market can be divided into two sectors: the investment grade sec- tor and the noninvestment grade sector. Distressed debt is a subcategory of noninvestment grade bonds. These bonds may be in bankruptcy pro- ceedings, may be in default of coupon payments, or may be in some other form of distress.
Factors Considered in Rating Corporate Bond Issues
In conducting its examination of corporate bond issues, the rating agen- cies consider the four Cs of credit: character, capacity, collateral, and covenants.
The first of the Cs stands for characterof management, the founda- tion of sound credit. This includes the ethical reputation as well as the business qualifications and operating record of the board of directors, management, and executives responsible for the use of the borrowed funds and repayment of those funds. The next C is capacityor the abil- ity of an issuer to repay its obligations. The third C, collateral, is looked at not only in the traditional sense of assets pledged to secure the debt, but also to the quality and value of those unpledged assets controlled by the issuer. In both senses the collateral is capable of supplying addi- tional aid, comfort, and support to the debt and the debt holder. Assets form the basis for the generation of cash flow which services the debt in good times as well as bad. The final C is for covenants, the terms and
EXHIBIT 2.1 Summary of Long-Term Bond Rating Systems and Symbols Fitch Moody's S&P Summary Description Investment Grade
AAA Aaa AAA Gilt edged, prime, maximum safety, lowest risk, and when sovereign borrower considered “default-free”
AA+ Aa1 AA+
AA Aa2 AA High-grade, high credit quality
AA- Aa3 AA-
A+ A1 A+
A A2 A Upper-medium grade
A- A3 A-
BBB+ Baa1 BBB+
BBB Baa2 BBB Lower-medium grade
BBB- Baa3 BBB-
Speculative Grade
BB+ Ba1 BB+
BB Ba2 BB Low grade; speculative
BB- Ba3 BB-
B+ B1
B B B Highly speculative
B- B3
Predominantly speculative, Substantial Risk or in Default
CCC+ CCC+
CCC Caa CCC Substantial risk, in poor standing CC Ca CC May be in default, very speculative
C C C Extremely speculative
CI Income bonds—no interest being paid DDD
DD Default
D D
conditions of the lending agreement. Covenants lay down restrictions on how management operates the company and conducts its financial affairs. Covenants can restrict management’s discretion. A default or violation of any covenant may provide a meaningful early warning alarm enabling investors to take positive and corrective action before the situation deteriorates further. Covenants have value as they play an important part in minimizing risk to creditors. They help prevent the unconscionable transfer of wealth from debt holders to equity holders.
Character analysis involves the analysis of the quality of manage- ment. In discussing the factors it considers in assigning a credit rating, Moody’s Investors Service notes the following regarding the quality of management:
Although difficult to quantify, management quality is one of the most important factors supporting an issuer’s credit strength.
When the unexpected occurs, it is a management’s ability to react appropriately that will sustain the company’s performance.1
In assessing management quality, the analysts at Moody’s, for exam- ple, try to understand the business strategies and policies formulated by management. Following are factors that are considered: (1) strategic direction, (2) financial philosophy, (3) conservatism, (4) track record, (5) succession planning, and (6) control systems.2
In assessing the ability of an issuer to pay, an analysis of the finan- cial statements is undertaken. In addition to management quality, the factors examined by Moody’s, for example, are (1) industry trends, (2) the regulatory environment, (3) basic operating and competitive posi- tion, (4) financial position and sources of liquidity, (5) company struc- ture (including structural subordination and priority of claim), (6) parent company support agreements, and (7) special event risk.3
In considering industry trends, the rating agencies look at the vul- nerability of the company to economic cycles, the barriers to entry, and the exposure of the company to technological changes. For firms in reg- ulated industries, proposed changes in regulations are analyzed to assess their impact on future cash flows. At the company level, diversification of the product line and the cost structure are examined in assessing the basic operating position of the firm.
1“Industrial Company Rating Methodology,” Moody’s Investor Service: Global Credit Research (July 1998), p. 6.
2“Industrial Company Rating Methodology,” p. 7.
3“Industrial Company Rating Methodology,” p. 3.
The rating agencies look at the capacity of a firm to obtain addi- tional financing and backup credit facilities. There are various forms of backup facilities. The strongest forms of backup credit facilities are those that are contractually binding and do not include provisions that permit the lender to refuse to provide funds. An example of such a pro- vision is one that allows the bank to refuse funding if the bank feels that the borrower’s financial condition or operating position has deterio- rated significantly. (Such a provision is called a material adverse change clause.) Noncontractual facilities such as lines of credit that make it easy for a bank to refuse funding should be of concern to the rating agency. The rating agency also examines the quality of the bank provid- ing the backup facility. Other sources of liquidity for a company may be third-party guarantees, the most common being a contractual agreement with its parent company. When such a financial guarantee exists, the analyst must undertake a credit analysis of the parent company.
A corporate debt obligation can be secured or unsecured. In our dis- cussion of creditor rights in a bankruptcy discussed later, we will see that in the case of a liquidation, proceeds from a bankruptcy are distributed to creditors based on the absolute priority rule. However, in the case of a reorganization, the absolute priority rule rarely holds. That is, an unse- cured creditor may receive distributions for the entire amount of his or her claim and common stockholders may receive something, while a secured creditor may receive only a portion of its claim. The reason is that a reor- ganization requires approval of all the parties. Consequently, secured cred- itors are willing to negotiate with both unsecured creditors and stockholders in order to obtain approval of the plan of reorganization.
The question is then, what does a secured position mean in the case of a reorganization if the absolute priority rule is not followed in a reor- ganization? The claim position of a secured creditor is important in terms of the negotiation process. However, because absolute priority is not followed and the final distribution in a reorganization depends on the bargaining ability of the parties, some analysts place less emphasis on collateral compared to the other factors discussed earlier and cove- nants discussed later.
Covenants deal with limitations and restrictions on the borrower’s activities. Affirmative covenants call upon the debtor to make promises to do certain things. Negative covenants are those which require the borrower not to take certain actions. Negative covenants are usually negotiated between the borrower and the lender or their agents. Borrowers want the least restrictive loan agreement available, while lenders should want the most restrictive, consistent with sound business practices. But lenders should not try to restrain borrowers from accepted business activities and conduct. A borrower might be willing to include additional restrictions (up
to a point) if it can get a lower interest rate on the debt obligation. When borrowers seek to weaken restrictions in their favor, they are often willing to pay more interest or give other consideration.
Factors Considered in Rating Sovereign Debt
While U.S. government debt is not rated by any nationally recognized statistical rating organization, the debt of other national governments is rated. These ratings are referred to as sovereign ratings. Standard &
Poor’s and Moody’s rate sovereign debt.
The two general categories used by S&P in deriving their ratings are economic risk and political risk. The former category is an assessment of the ability of a government to satisfy its obligations. Both quantitative and qualitative analyses are used in assessing economic risk. Political risk is an assessment of the willingness of a government to satisfy its obliga- tions. A government may have the ability to pay but may be unwilling to pay. Political risk is assessed based on qualitative analysis of the economic and political factors that influence a government’s economic policies.
There are two ratings assigned to each national government. The first is a local currency debt rating and the second is a foreign currency debt rating. The reason for distinguishing between the two types of debt is that historically, the default frequency differs by the currency denom- ination of the debt. Specifically, defaults have been greater on foreign currency-denominated debt.4
The reason for the difference in default rates for local currency debt and foreign currency debt is that if a government is willing to raise taxes and control its domestic financial system, it can generate sufficient local currency to meet its local currency debt obligation. This is not the case with foreign currency-denominated debt. A national government must purchase foreign currency to meet a debt obligation in that foreign cur- rency and therefore has less control with respect to its exchange rate.
Thus, a significant depreciation of the local currency relative to a for- eign currency in which a debt obligation is denominated will impair a national government’s ability to satisfy such obligation.
The implication of this is that the factors both rating agencies ana- lyze in assessing the creditworthiness of a national government’s local currency debt and foreign currency debt will differ to some extent. In assessing the credit quality of local currency debt, for example, S&P emphasizes domestic government policies that foster or impede timely debt service. The key factors looked at by S&P are:
4David T. Beers, “Standard & Poor’s Sovereign Ratings Criteria,” Chapter 24 in Frank J. Fabozzi (ed.), The Handbook of Fixed Income Securities: Fifth Edition (Burr Ridge, IL: Irwin Professional Publishing, 1997).
30 CREDIT DERIVATIVES: INSTRUMENTS, APPLICATIONS, AND PRICING
■ Stability of political institutions and degree of popular par- ticipation in the political process.
■ Economic system and structure.
■ Living standards and degree of social and economic cohesion.
■ Fiscal policy and budgetary flexibility.
■ Public debt burden and debt service track record.
■ Monetary policy and inflation pressures.5
The single most important leading indicator according to S&P is the rate of inflation.
For foreign currency debt, credit analysis by S&P focuses on the inter- action of domestic and foreign government policies. S&P analyzes a coun- try’s balance of payments and the structure of its external balance sheet.
The area of analysis with respect to its external balance sheet are the net public debt, total net external debt, and net external liabilities.
Bankruptcy and Creditor Rights in the United States
The holder of a corporate debt instrument has priority over the equity owners in the case of bankruptcy of a corporation. There are creditors who have priority over other creditors. Here we will provide an over- view of the bankruptcy process and then look at what actually happens to creditors in bankruptcies.
The Bankruptcy Process
The law governing bankruptcy in the United States is the Bankruptcy Reform Act of 1978 as amended.6One purpose of the act is to set forth the rules for a corporation to be either liquidated or reorganized. The liq- uidation of a corporation means that all the assets will be distributed to the holders of claims of the corporation and no corporate entity will sur- vive. In a reorganization, a new corporate entity will result. Some holders of the claim of the bankrupt corporation will receive cash in exchange for their claims, others may receive new securities in the corporation that results from the reorganization, and others may receive a combination of both cash and new securities in the resulting corporation.
Another purpose of the Bankruptcy Act is to give a corporation time to decide whether to reorganize or liquidate and then the necessary time to formulate a plan to accomplish either a reorganization or liquidation.
5Beers, “Standard & Poor’s Sovereign Ratings Criteria.”
6For a discussion of the Bankruptcy Reform Act of 1978 and a nontechnical descrip- tion of its principal features, see Jane Tripp Howe, “Investing in Chapter 11 and Other Distressed Companies,” Chapter 18 in Frank J. Fabozzi (ed.),Handbook of Corporate Debt Instruments (New Hope, PA: Frank J. Fabozzi Associates, 1998).
This is achieved because when a corporation files for bankruptcy, the Act grants the corporation protection from creditors who seek to collect their claims. The petition for bankruptcy can be filed either by the com- pany itself, in which case it is called a voluntary bankruptcy, or be filed by its creditors, in which case it is called an involuntary bankruptcy. A company that files for protection under the bankruptcy act generally becomes a “debtor-in-possession” (DIP), and continues to operate its business under the supervision of the court.
The Bankruptcy Act is comprised of 15 chapters, each chapter covering a particular type of bankruptcy. Of particular interest to us are two of the chapters, Chapter 7 and Chapter 11. Chapter 7 deals with the liquidation of a company; Chapter 11 deals with the reorganization of a company.
Absolute Priority: Theory and Practice
When a company is liquidated, creditors receive distributions based on the
“absolute priority rule” to the extent assets are available. The absolute pri- ority rule is the principle that senior creditors are paid in full before junior creditors are paid anything. For secured creditors and unsecured creditors, the absolute priority rule guarantees their seniority to equity holders.
In liquidations, the absolute priority rule generally holds, In con- trast, there is a good body of literature that argues that strict absolute priority has not been upheld by the courts or the SEC.7Studies of actual reorganizations under Chapter 11 have found that the violation of abso- lute priority is the rule rather the exception.8
There are several hypotheses that have been suggested as to why in a reorganization the distribution made to claim holders will diverge from that required by the absolute priority principle.
The incentive hypothesis argues that the longer the negotiation pro- cess among the parties, the greater the bankruptcy costs and the smaller
7See, for example, William H. Meckling, “Financial Markets, Default, and Bank- ruptcy,”Law and Contemporary Problems, 41 (1977), pp. 124–177; Merton H.
Miller, “The Wealth Transfers of Bankruptcy: Some Illustrative Examples,” Law and Contemporary Problems, 41 (1977), pp. 39–46; Jerold B. Warner, “Bankrupt- cy, Absolute Priority, and the Pricing of Risky Debt Claims,” Journal of Financial Economics, 4 (1977), pp. 239–276; and, Thomas H. Jackson, “Of Liquidation, Continuation, and Delay: An Analysis of Bankruptcy Policy and Nonbankruptcy Rules,”American Bankruptcy Law Journal, 60 (1986), pp. 399–428.
8See: Julian R. Franks and Walter N. Torous, “An Empirical Investigation of U.S. Firms in Reorganization,” Journal of Finance (July 1989), pp. 747–769; Lawrence A. Weiss,
“Bankruptcy Resolution: Direct Costs and Violation of Priority of Claims,” Journal of Financial Economics(1990), pp. 285–314; and Frank J. Fabozzi, Jane Tripp Howe, Takashi Makabe, and Toshihide Sudo, “Recent Evidence on the Distribution Patterns in Chapter 11 Reorganizations,” Journal of Fixed Income (Spring 1993), pp. 6–23.