Assessing Default Risk: Techniques and Models for Fixed Income Credit Analysts

Corporate entities, governments, and other organizations issue debt securities in financial markets to raise funds. Investors keep a tab on these debt securities as they provide a fixed source of income. Debt or fixed-income securities showcase that an organization has borrowed funds. Besides repaying the principal amount to the investor, the borrower offers regular interest payments. Since the investor receives regular interest payments, these are called fixed-income securities. Investors should judge the creditworthiness and risk of default before choosing debt security. It is where fixed income credit analysts come into the picture. Read on to understand the best techniques and models for fixed-income credit analysts to assess default risk.

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Demystifying fixed-income credit analysis

Fixed-income credit analysis helps assess the risk of default associated with debt securities. With the help of fixed-income credit analysis, investors can understand the credit risk associated with the borrower or debt security issuer. A wide range of fixed-income securities are issued, like bonds, notes, and debentures. Investors cannot put their money mindlessly in these debt securities without a credit evaluation. What if the issuer fails to generate cash flow and defaults on the principal repayment? To avoid such an issue, investors depend on fixed-income credit analysis. Besides determining the risk of default, fixed-income analysts also help analyze the returns. They also analyze the creditworthiness of the issuer based on different models.

Fixed-income credit analysts have a wide range of responsibilities, like:

  • Fixed-income credit analysts try to understand the financial performance of the issuer. A rigorous credit analysis is performed to understand the issuer’s financial stability.
  • Fixed-income credit analysts predict the chances of default for investors. Based on the market conditions, past payments, and the issuer’s financial performance, analysts predict the chances of timely interest and principal repayments.
  • Credit analysts advise investors on which debt securities to buy, sell, or hold. Since they can evaluate the credit risk associated with different securities, they can help make informed investment decisions.
  • Credit analysts also monitor the payments from the issuer and the market conditions. The credit risk associated with an organization can rise with time. If the issuer’s credit score is falling, analysts can inform the investors about it. Based on the changing conditions, investors can prepare exit strategies.
  • Fixed income credit analysts are responsible for investment reporting. They might have asset managers, individual investors, and organizations as clients. With investment reporting, clients can be updated regarding the performance of debt securities.

Techniques/models for fixed-income credit analysts to evaluate default risk

Credit analysts use various techniques and models to assess default risk. Here are the most effective ones:

Credit score of the issuer

Checking the issuer’s credit score is among the first steps for fixed-income credit analysts. By checking the issuer’s credit score, analysts get an idea of creditworthiness. Issuers that have not met previous payments timely will have a poor score. On the other hand, issuers with a proven track record of timely payments will have better credit scores.

Financial statements analysis

Credit analysts review the issuer’s financial statements to identify the default risk. Balance sheets, cash flows, and other financial statements are thoroughly examined to determine default risk. When an issuer sells debt securities, it has certain obligations to meet. For example, the issuer must pay timely interest to the investors. With financial statements or fundamental analysis, credit analysts can determine the issuer’s ability to meet financial obligations toward the investors.

Credit spreads method

Since the risk of default is usually higher with debt securities, the yield is also high. As a result, the issuer provides more interest to investors to compensate for the increased default risk. With the credit spreads method, the debt securities yield is compared to a risk-free investment. When the two differ more, the credit spread is wider. Credit analysts keep a check on the credit spreads to determine the default risk. Wider credit spreads mean the risk of default is high for investors.

Use of credit scoring models

Credit scores are given to organizations by independent institutions. Fixed income credit analysts can use the score offered by an unbiased organization to gauge the risk of default. Alternatively, they can use an automated credit scoring model to determine the issuer’s creditworthiness. A credit scoring model will analyze historical data to assign a credit score to the issuer.

Besides the aforementioned models/techniques, credit analysts also rely on stress testing, default probability models, macroeconomic analysis, and other methods.

In a nutshell

Fixed income credit analysts have a crucial role in determining the risk of default associated with debt securities. Asset managers, investors, and organizations depend on their service to make informed decisions while investing in debt securities. Learn more about the techniques to determine default risk for fixed-income securities!