Fixed Income Analysis, Second Edition

CHAPTER 15

GENERAL PRINCIPLES OF CREDIT ANALYSIS

I. INTRODUCTION

The credit risk of a bond includes:

1. the risk that the issuer will default on its obligation and

2. the risk that the bond’s value will decline and/or the bond’s price performance will be worse than that of other bonds against which the investor is compared because either (a) the market requires a higher spread due to a perceived increase in the risk that the issuer will default or (b) companies that assign ratings to bonds will lower a bond’s rating.

The first risk is referred to as default risk. The second risk is labeled based on the reason for the adverse or inferior performance. The risk attributable to an increase in the spread, or more specifically the credit spread, is referred to as credit spread risk; the risk attributable to a lowering of the credit rating (i.e., a downgrading) is referred to as downgrade risk.¹⁹⁸

Credit analysis of any entity—a corporation, a municipality, or a sovereign government —involves the analysis of a multitude of quantitative and qualitative factors over the past, present, and future. There are four general approaches to gauging credit risk:

• credit ratings

• traditional credit analysis

• credit scoring models

• credit risk models

In this chapter, we discuss each approach. Our primary focus is on the credit analysis of corporate bonds.

II. CREDIT RATINGS

A credit rating is a formal opinion given by a specialized company of the default risk faced by investing in a particular ...