Fundamentals of Credit Analysis—Introduction
There is a lot of debt out there.
Trillions and trillions of US dollars worth of debt exists, and thus the debt market is huge. Credit analysis is the backbone of this market, as investors work to accurately allocate resources toward opportunities with appropriate ratios of reward to risk.
A discussion of __credit risk__ starts with __default probability__ and __loss severity__: what are the chances of loss, and how much would be lost if there really is a default. This differs among issuers. There is plenty of __corporate debt__, as well as __sovereign debt__ issued by nations and __sub-sovereign debt__ issued by local governments or municipalities.
Which issuer do you think might have the lowest credit risk?
No, this isn't the issuer with the lowest credit risk. Consider the power of each entity in accessing money.
That's right!
Sovereign issuers can tax and also have direct or indirect access to creation of new money. So, there's little risk with these issuers.
No, this is one of the higher-credit risk issuers. Think about the issuers in terms of power.
For corporate issuers, __capital structure__ is important to consider. It can get complicated as to who has what claim to what part of the company. The first in line for payment have the best __seniority ranking__, and this is part of a larger discussion about the __priority of claims__.
Who do you think might be first in line for payment?
Yes!
This is most likely because of the power of market forces. An investor would be willing to accept a lower-yield bond if it was safer, so it's most likely that this is an investor with a more senior claim.
No, this is less likely than another. Consider the relative risk and expected return associated with each.
No, owners are stockholders and they are always behind bondholders in terms of claims to a firm's assets.
To summarize this discussion:
[[summary]]
__Ratings agencies__ amass a large amount of information to come up with __credit ratings__ for various issuers. __Credit spreads__ are analyzed, including their impact on risk and return. Both yields and spreads can be decomposed into parts for further analysis. __High-yield debt__ is very risky debt which can achieve "junk" status by ratings agencies, and analysis of these instruments require special care.
These topics and many more are at the start of an appreciation for the fundamentals of credit analysis. But information that can affect just 1% of 1% of a bond market in the many trillions of dollars is still information well worth having.
Corporate issuer
Sovereign issuer
Sub-sovereign issuer
A bondholder with a low-yield bond
A bondholder with a high-yield bond
An owner of the firm with the power to fire management
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