Chapter 24 PrinciplesPrinciples

ofof

CorporateCorporate

FinanceFinance

Ninth Edition

Credit Risk and the Value of

Corporate Debt

Slides by

Matthew Will

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved

McGraw Hill/Irwin

24- 2

Topics Covered

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

24- 3

Defaulting Debt Levels$

Mil

lion

sFace value of defaulting debt

24- 4

Valuing Risky Bonds

The risk of default changes the price of a bond and the YTM.

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:

24- 5

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

24- 6

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

24- 7

Yield Spreads

Yie

ld S

prea

d, %

24- 8

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.

24- 9

The Default Option

Example - Circular File borrowed $50 per share, but then the firm fell on hard times and the market value of its assets fell to $30. Circular’s bond and stock prices fell to $25 and $5, respectively. Thus Circular’s market-value balance sheet is:

Circular File Company (market values)

Asset value $30 $25 Bonds$ 5 Stock

$30 $30 Firm value

Circular File Company (market values)

Asset value $30 $25 Bonds=Asset value – call value$ 5 Stock=value of a call

$30 $30 Firm value=Asset value

24- 10

The Default Option

Example (continued) - The value of Circular’s common stock is the value of a call option on the firm’s assets with an exercise price of $50.

24- 11

Interest Rates, Risk, and Maturity

0

1

2

3

4

5

1 3 5 7 9 11 13 15 17 19 21 23 25

Leverage = 100%Leverage = 60%Leverage = 40%Leverage = 20%

Difference between promised yield on bond and risk-free rate, percent

Maturity, years

24- 12

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.

24- 13

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).

24- 14

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

24- 15

Predicting DefaultA comparison of financial

statements from firms that have gone bankrupt with those firms

that have not gone bankrupt reveals information valuable to

the lending decision.

Financial ratios of 544 failing and non-failing firms.

24- 16

Credit Analysis

Predicting Default - William Beaver, Maureen McNichols, and Jung-Wu Rhie, studied defaulting and non-defaulting firms and concluded the chance of failing during the next year relative to the chance of not failing was best estimated by the following equation:

L failure of chacne Relative

/346./307.2192.1445.6

failure) of chance (relative Log

e

sliabilitieEBITDAassetssliabilitieROA

24- 17

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.

24- 18

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

24- 19

Default Probability

0

5

10

15

20

25

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

Prob

abil

ity

of d

efau

lt

over

nex

t yea

rMoody’s estimate of WorldCom’s probability of default

Default date

24- 20

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

24- 21

Value at Risk (VaR)

Standard Measurements10 days

99% confidence interval

VaR

1010 day

33.2%99

easset valu)33.2( 10 VaR

24- 22

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

24- 23

Value at Risk (VaR)

ExampleYou also own $5 mil of AT&T, with a daily volatility of

1%. AT&T and IBM have a .7 correlation coefficient. What is the VaR of AT&T and the combined portfolio?

405,368$

621,473,1$

&

TAT

IBM

VaR

VaR

026,842,1$& IBMTATVaR

379,751,1$PortfolioVaR

647,90$BenefitationDiversific

24- 24

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

24- 25

Yields and Ratings

Rating after 1-year

Percent yield for given

rating

Implied percentage change in price for

Alcan bonds

AAA 4.43 2.9AA 4.56 1.9A 4.8 0.2BBB 5.4 -4BB 9.45 -27.5B 11.7 -37.3CCC 15.15 -49.4Default - -52.9

average yields for rated bonds October 2003average recovery rate for unsecured bonds 1988-2002

Alcan bond price changes, relative to changes in the bond rating

24- 26

Web Resources

www.mooodys.com

www.standardandpoors.com

www.chinca.org/

www.bondsonline.com

www.moodyskmv.com/

www.riskmetrics.com

Click to access web sitesClick to access web sites

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