ESG and Credit Valuation The analysis of capacity to repay debt will provide the analysts with a good picture of the company's business, the risks it faces including ESG risks, and how they are managed. However, it is crucial for fixed income analysts to understand how those risks impact the actual debt instruments that the company has issued. Because the debt instrument will have specific characteristics, not all risks will be relevant to all instruments. For example, the impact of climate change on an issuer due to physical or transition risks may be very long-term affecting the company in many years or even decades time. It is unlikely that the risks will have any significant impact on a fixed income security, such as a corporate bond with three or five years until maturity. Analysts also consider fixed income security features, such as the level of seniority relative to other instruments and the pattern of expected cash flows in the form of regular, usually fixed coupons, and the final repayment of the par value. Also, the analysts will need to consider any additional features to the bond such as embedded options. We have seen what could be the relevant ESG and non-ESG factors in credit analysis. The actual credit analysis models used in practice are highly mathematical. The analysis involves an estimation of the probability of default and in conjunction with a loss given default, they allow the analyst to calculate the expected loss. The present value of the expected loss then forms the basis of the so-called credit valuation adjustment. The credit valuation adjustment is the amount by which the value of the corporate bond, assuming no default, needs to be adjusted to give the fair value of the corporate bond. In practice, credit risk assessment involves the consideration of internal or external default data and uses statistical approaches that can be calibrated and validated. A blend of risk analysis, quantitative analysis, and financial analysis supplemented by qualitative assessments based on expert judgment approaches is used. The resulting fair value of the corporate bond can then be used to make an investment decision. Let's say, for example, that in a default-free scenario, a bond would be worth 106. Using the default analysis that gives the credit valuation adjustment, the analyst comes up with a fair value of 103, yet the bond is trading at 101. This could be considered as a buying opportunity. If, however, the bond is trading above the fair value that the analyst has calculated, then this suggests the bond is overvalued and investors should instead sell the bond.
