4. The Building Blocks of Credit Analysis and Credit Risk Rating

For a primer on this subject, see Nagy, Pancras J. (1984), Country Risk: How to Assess, Quantify, and Monitor It, London: Euromoney Publications, 1984; Mina Toksoz and The Economist, Guide to Country Risk: How to Identify, Manage and Mitigate the Risks of Doing Business Across Borders, December 2014. Country risk ratings are provided by credit risk rating agencies such as Fitch and Moody’s, and political risk analysis organisations such as EIU (Economist Intelligence Unit). See EIU, Country Risk Model: An Interactive Tool for Analysing Country and Sovereign Risk.

Porter, M. (1980), Competitive Strategy: Techniques for Analyzing Industries and Competitors, The Free Press.

See Porter, op. cit. page 158. The author acknowledges certain “legitimate criticisms” of the life cycle approach and the S-curve depiction.

In a competitive market, a firm minimises costs at the lowest point on its short run average cost curve where ATC (average total cost) = MC (marginal cost) because MC always cuts ATC at the lowest point on the ATC curve.

The markup rule says \( P= MC\ \left(\frac{\in_p}{1+{\in}_p}\right) \). Divide the numerator and denominator of the term in bracket by ∈_p, and the result is \( P= MC\ \left(\frac{1}{\eta +1}\right) \), where Ƞ = 1/∈_p.

NBER (The National Bureau of Economic Research). NBER website: http://​www.​nber.​org

Berman J., and Pfleeger J., (1997), Which industries are sensitive to business cycles? Monthly Labor Review, February.

Not all labour is variable cost. In the software and pharmaceutical industries, companies do not lay off R&D workers in response to lower sales. Typically, the jobs in sales positions are amongst the first to feel the cutbacks.

Standard and Poor’s (2013), General Criteria, Methodology: Industry Risk,S&P, November, Ratings Direct, November 19, 2013.

See S&P (2008), Understanding Standard & Poor’s Rating Definitions. “BBB” stress scenario: An issuer or obligation rated “BBB” should be able to withstand a moderate level of stress and still meet its financial obligations. A GDP decline of as much as 3% and unemployment at 10% would be reflective of a moderate stress scenario. A drop in the stock market by up to 50% would similarly indicate moderate stress.

“BB” stress scenario: An issuer or obligation rated “BB” should be able to withstand a modest level of stress and still meet its financial obligations. For example, GDP might decline by as much as 1% and unemployment might reach 8%. The stock market could drop by up to 25%.

Government of Canada, Competition Bureau, op. cit.

Load Factor: The number of revenue passenger miles (RPMs) expressed as a percentage of available seat miles (ASMs), either on a particular flight or for the entire system. Load factor represents the proportion of airline output that is actually consumed. To calculate this figure, divide RPMs by ASMs. Load factor for a single flight can also be calculated by dividing the number of passengers by the number of seats. The increases in load factor as well as passenger revenue per available seat mile (PRASM) are positive indicators of efficiency, and reflect the company’s strong operational capabilities. The increased load factor will result in higher margins as the company is able to generate more passenger revenue for the same fixed cost.

It is incumbent on those who dismiss history as guide to the future to explain why the expansion will go on expanding forever, just as in the reverse, when the economy is in recession, that it will go on declining forever.

Astolfi, R. (2016), Did the OECD Composite Leading Indicator See It Coming? OECD Statistics Directorate, OECD Insights.

The precursor to the 1980s economic recession—including the double dip—was the spiralling inflation that slightly topped 14% in the first half of 1980. The Federal Reserve tightened monetary policy and the Fed Funds rate climbed to as high as 20% in 1981 before the inflation rate fell back, to 2.4% by July 1982. In the early 1990s, the economy was already weak when business and consumer confidence had already taken a beating due to the spike in oil prices after Iraq invaded Kuwait on August 2, 1990. In the 2008–2009 recession, the underlying cause was the financial crisis, the worst since the Great Depression. Inflation had been rather tame and interest rates had been low and stable since the mid-1980s. A real estate bubble got underway in the mid-1990s, inflated by subprime mortgages, which in turn led to the proliferation of mortgage-backed securities known as CDOs (collateralised debt obligation). The collapse of the real estate market triggered a deep financial crisis, all of which contributed to the recession.

Congressional Budget Office (2016), An Update to the Budget and Economic Outlook 2016–2026, Congress of the US CBO. See projections for the unemployment rate and potential GDP growth in Tables 2.​1 and 2.​3 respectively. The natural rate of unemployment (NAIRU) is the non-accelerating inflation rate of unemployment, or U∗. It is the lowest level that unemployment can reach without generating excess inflation. Below this long-run rate, wage and price inflation spirals upward. NAIRU, like the natural rate of interest—the rate of interest at which the central bank is neither stimulating nor restraining the economy—is often called “starred” variables. The asterisk is used to indicate that the variables must be estimated as there is uncertainty around them depending on the measurement approach. It does not mean, however, that because NAIRU is unobservable it does not exist. Still, the Federal Reserve uses an estimate of the NAIRU to help guide monetary policy, In the FAQs, What is the lowest level of unemployment that the U.S. economy can sustain? The Board of Governors of the Federal Reserve System responded: “Many estimates suggest that the long-run normal level of the unemployment rate – the level that the unemployment rate would be expected to converge to in the next 5 to 6 years in the absence of shocks to the economy – is in a range between 4.5 and 6 percent. Policymakers’ judgements about the long-run normal rate of unemployment in the Summary of Economic Projections are generally in this range as well. For example, in the September 2017 projections, FOMC participants’ estimates of the longer-run normal rate of unemployment ranged from 4.4 to 5.0 percent.” Economists have consistently underestimated U∗. The US unemployment rate has been steadily declining from 4.4% in March 2017 and has dipped below 4% since March 2019. Whilst wage inflation has been remarkably tame, around 3%, it has been approaching the 3.5% peak of Q1:2007. The economy went into recession three-quarters later in December 2008.

The pre-emption of inflation rests on (a) the fact that monetary (and fiscal) policy act slowly and with varying lags, and (b) the Phillips Curve model, or more accurately the modified Phillips Curvemodel. The modified version states that this year’s inflation rate (π_t) is the result of this year’s expectation of the inflation rate (\( {\pi}_t^e \)), the markup on prices (m), the various factors in wage determination (z), and the current unemployment rate (U_t). In symbols:

The first equation of the model describes how people form their expectations of inflation; the higher the value of Ѳ, the more of last year’s inflation leads workers and employers to revise their expectations of this year’s inflation rate. The second equation says that this years’ inflation rate is influenced by the expected inflation, the markup and the factors that influence wage determination (z), and the unemployment rate. This last one captures capacity utilisation. The third equation says that when Ѳ = 1, the change in the inflation rate (π_t – π_t-1), not the level (π_t), is positively related to (m + z) and negatively related to U_t. As a first cut, we looked at US data (1996–2018) and the correlations. The (negative) correlation coefficient between the unemployment rate and the capacity utilisation rate is relatively high (−0.7). The coefficient for the change in the inflation rate and the unemployment is, however, virtually zero, implying that the level of the unemployment rate and hence domestic capacity utilisation rate have been contributing very little to the change (acceleration or deceleration) in the level of inflation. Globalisation and hence international capacity utilisation appears to be a more important factor than domestic capacity utilisation in explaining domestic inflation. For a related article, see Federal Reserve Bank of San Francisco, Inflation – Stress-Testing the Phillips Curve, Òscar Jordà, Chitra Marti, Fernanda Nechio, and Eric Tallman, February 11, 2019.

For coverage of corporate governance, see B. Ganguin and J., Bilardello, Fundamentals of Corporate Credit Analysis, Chapter 4, ibid.

There are many textbooks on money market and fixed-income securities. Some of the better known ones include Marcia Stigum, The Money Market, McGraw-Hill, 3rd edition, December 1, 1989; and Frank J. Fabozzi, The Handbook of Fixed-Income Securities, McGraw-Hill Education, 8th edition, January 6, 2012.

Fabozzi, F.J., Davis, H.A, and Choudhry, M. (2006), Introduction to Structured Finance, John Wiley and Sons. The authors explain there is no single and all-encompassing definition of structured finance, although you know it by numerous characteristics. Some structured finance products include ABS (asset-backed securities). These are bonds or notes backed by financial assets such as receivables, auto loans, and home-equity loans. Structured finance also includes riskier CDOs (collateralised debt obligations) that were “backed” by pooled assets such as bonds, loans, and mortgages—including the notorious subprime mortgages that went sour in 2007 and caused a global financial crisis in 2008.

On financial forecasting methods, see Chapter 3 of Robert C. Higgins, Analysis for Financial Management, 5th edition, Irwin-McGraw Hill; Ganguin & John Bilardello, ibid., Chapter 6.