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(BQ) Part 2 book "Corporate bond portfolio management" has contents: Introduction to corporate bond credit analysis, valuation of subordinated structures, early redemption features, credit risk and embedded options, a rating transition framework for corporate bond strategy,.and other contents. | Section III Corporate Credit Risk 161 Chapter 11 Credit Risk A n investor who lends funds by purchasing a corporate bond issue is exposed to three types of credit risk: (1) default risk, (2) credit spread risk, and (3) downgrade risk. In this chapter we discuss these risks. At the end of the chapter we introduce instruments to protect against credit risk. DEFAULT RISK Traditionally, credit risk is defined as 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. This form of credit risk is called default risk. If a default does occur, this does not mean the investor loses the entire amount invested. There is a certain percentage of the investment that can be expected to be recovered. This is called the recovery rate. Credit Ratings Professional money managers use various techniques to analyze information on companies and bond issues in order to estimate the probability that the issuer will live up to its future contractual obligations (i.e., to assess their risk of default) and the severity of a loss if one occurs. (This activity is known as credit analysis and we’ll cover this topic in Chapter 12.) Some institutional investors and most investment banking firms have their own credit analysis departments to assess default risk. Institutional investors also rely on nationally recognized statistical rating organizations that perform credit analysis and issue their conclusions in the form of ratings. These organizations, commonly referred to as “rating agencies,” are (1) Moody’s Investors Service, (2) Standard & Poor’s Corporation, and (3) Fitch. The rating systems use similar symbols, as shown in Exhibit 1. In all rating systems the term “high grade” means low credit risk, or conversely, high probability of future payments. The highest-grade bonds are designated by Moody’s by the letters Aaa, and by the others as AAA. The next highest grade is Aa (Moody’s)
