Chapter 23 PrinciplesPrinciples

ofof

CorporateCorporate

FinanceFinance

Tenth Edition

Credit Risk and the Value of

Corporate Debt

Slides by

Matthew Will

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Topics Covered

Yields on Corporate DebtThe Option To DefaultBond Ratings and the Probability of DefaultPredicting the Probability of DefaultValue at Risk

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Valuing Risky Bonds

Example

We have a 5% 1 year bond. The bond is priced at par of $1000. But, there is a 20% chance the company will go into bankruptcy and only pay $500. What is the bond’s value?

A: Bond Value Prob

1,050 .80 = 840.00

500 .20 = 100.00 .

940.00 = expected CF

%3.171895

1050

895$05.1

940

YTM

Value

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Valuing Risky Bonds

Example – Continued

Conversely - If on top of default risk, investors require an additional 3 percent market risk premium, the price and YTM is as follows:

%7.20100.870

1050

00.870$08.1

940

YTM

Value

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Yield Spreads

Yie

ld S

prea

d, %

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Credit Default Swap DataSp

read

, %Credit default swaps insure holders of corporate bonds against default. Dow Jones indexes of spreads on default swaps measure the annual insurance premium.

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Key to Bond Ratings

Moody's S&P's & Fitch

Investment GradeAaa AAAAa AA A A

Baa BBBJunk Bonds

Ba BB B B

Caa CCCCa CC C C

The highest quality bonds are rated triple-A.

Investment grade bonds have to be equivalent of

Baa or higher. Bonds that don’t make this cut are called “high-yield” or

“junk” bonds.

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Bond Ratings and Financial Ratios

Ratio AAA AA A BBB BB B CCC

EBIT interest cover * 23.8 19.5 8 4.7 2.5 1.2 0.4return on capital % 27.6 27 17.5 13.4 11.3 8.7 3.2Total debt/capital % 22.9 28.3 37.5 42.5 53.7 75.9 113.5

* Earnings before interst and tax divided by interest

Three years of median ratio data by bond rating (2002– 2004).

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Bond Ratings and Default

Rating at Time of Issue

1 Year after issue

5 Years after Issue

10 Years after Issue

AAA 0 0.1 0.6AA 0 0.3 0.9

A 0 0.6 1.9BBB 0.3 3.1 6.6BB 1.2 12.7 24B 5.9 30.5 44.8

CCC 30.4 56 67.7

Percentage Defaulting Within

Default rates of corporate bonds 1981-2005 by S&P’s rating at time of issue

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Credit Analysis

Credit analysis is only worth while if the expected savings exceed the cost.– Don’t undertake a full credit analysis unless the

order is big enough to justify it.– Undertake a full credit analysis for the doubtful

orders only.

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Asset Value and Default

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

27/0

9/200

1

1/11

/2001

7/12

/2001

15/0

1/200

2

21/0

2/200

2

28/0

3/200

2

3/5/2

002

10/6

/2002

19/0

7/200

2

Market value of assets

Default points

Val

ue, $

mil

lion

sThe market value of WorldCom assets, as default approached

Default date

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Value at Risk (VaR)

Value at Risk = VaR

Newer termAttempts to measure riskRisk defined as potential lossLimited use to risk managers

FactorsAsset valueDaily VolatilityDays Confidence interval

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Value at Risk (VaR)

Standard Measurements10 days

99% confidence interval

VaR

1010 day

33.2%99

easset valu)33.2( 10 VaR

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Value at Risk (VaR)Example

You own a $10 mil portfolio of IBM bonds. IBM has a daily volatility of 2%. Calculate the VaR over a 10 day time period at a 99% confidence level.

%74.14

33.20632.)%(99

621,473,1$

000,000,101473.

VaR

%32.6

1002.10

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Ratings Changes

Start of year, % AAA AA A BBB BB B CCC DefaultAAA 92.08 7.09 0.63 0.15 0.06 0 0 0AA 0.62 90.83 7.76 0.59 0.06 0.1 0.02 0.01A 0.05 2.09 91.37 5.79 0.44 0.16 0.04 0.05

BBB 0.03 0.21 4.1 89.38 4.82 0.86 0.24 0.37BB 0.03 0.08 0.4 5.53 83.25 8.15 1.11 1.45B 0 0.08 0.27 0.34 5.39 82.41 4.92 6.59

CCC 0.1 0 0.29 0.58 1.55 10.54 52.8 34.14

Rating at end of year