DEFAULT RISK AND BONDS Measuring risk and return on risky bonds yield-to-maturity on a risky bond quality spreads, the risk premium ,and default risk variation in quality spreads determinants of differences in spreads between issuers cyclical behavior of quality spreads Quality spreads and term-to-maturity normal view crisis-at-maturity
Prediction of default rates financial ratios as predictors of default bond ratings and the probability of default how well do ratings predict default
4 outcomes associated with investment in bonds full payment, default, exchange, or call relative probabiblities depends on credit quality digression on measuring default rates
Evaluating the risk of investing in debt by ratings category illiquidity, interest rate risk, and risk of default “market model” for bond returns segmenting by ratings category
MEASURING RISK AND RETURN ON RISKY BONDS The CAPM method: E( r j ) = r f + β* [E( r M ) - r f ]
where the risk premium is E( r j ) - r f = B* [E( r M - r f )]
The conventional method for bonds: (i)
compute the yield-to-maturity on risky bond, y in T
C M + t (1+ y )T t=1 (1+ y )
Po =∑
where C and M are the promised payments on the risky bond.
(ii) compute the yield-to-maturity on a matched default-free bond
(iii) compute the quality spread = yield on risky bond - yield on default-free bond
Yield-to-maturity = ex post return only if all payments are made on a timely basis and interest rates are constant.
Expected cash flows are less than promised cash flows, so expected return must also be less than promised yield.
Conventional quality spread > CAPM risk premium Quality spread = risk premium + expected loss due to default
A couple of examples
Comments on quality spread 1. Quality spread increases as default risk and risk premium increase.
2. Quality spread is the same for every participant and reflects the market's expected return on a bond. Individual investors may have different forecasts of return.
3. May have problems matching to a default free bond when yield curve is sloped.
A recent example Envirotest Systems’ 9 5/8% of 2003 had a yield of 15.48% in July 1998
At time P = 76
The bond was a senior subordinated note offered @ par in ‘98
Do you expect to earn 15.46%?
Some relevant info Bond is rated Caa
Envirotest’s 1995 ROA was –3.25%
Envirotest’s 1995 fixed charge coverage ratio was 0.29, down from 1.72 in the year of issue
Envirotest’s 1995 capital structure was almost 92% debt
Determinants of quality spreads on corporate debt - the Fisher study yc - y g = α+ β1 * σ2c + β2 * LSOLV c + β3 * (E / D )c + β4 * MVPDc
σ2c 1
=
variance in firm c's earnings
LSOLVc
=
length of time firm c was solvent
(E/D)c
=
equity to debt ratio for firm c
MVPDc = market value of all publicly traded debt issued by c
R2 = 0.75 for Fisher's regression model
First three variables measure potential for insolvency, fourth intended to control for liquidity differences.
Findings: all coefficients have predicted signs.
Cyclical behavior of quality spreads
Spreads rise before and during early stages of recessions
Spreads fall during early stages of recovery and expansion
Term structure of quality spreads on risky debt What should the yield curve for risky debt look like? • the normal risk adjustment
yield
risky
default free
maturity
The crisis at maturity
yield
risky
default free
maturity
ASSESSING THE RISK OF DEFAULT 1. Predicting default using financial ratios - credit scoring Use financial ratios to build statistical models that predict default or probability of default. Altman's study looked at twenty-two ratios and found the "best" five. Used data in five year period before bankruptcy. Ratios: working capital/TA, retained earnings/TA, market value of equity/book value of debt, sales/TA, and earnings before interest & taxes/TA.
2. Bond Ratings as "expert analysis" of default risk Ratings services classify debt according to perceived risk of default. Broadest classication of default prospects is investment grade and speculative grade. For Moody's investment grade is Aaa, Aa, A, and Baa. Speculative grade is any rating less than Baa. For S&P investment grade is AAA, AA, A, and BBB. Speculative grade is any rating less than BBB. Two types of speculative grade debt or junk bonds: Fallen Angels vs New-issue junk Relative proportions vary across time l Bond ratings begin with a credit-scoring model and then incorporate additional relevant information.
How well do bond ratings predict default? How are defaults distributed across ratings categories? Anecdotes (like WPPSS) vs statistical evidence
Timeliness of changes in ratings anecdotes on tardiness relative to economic events incentives of rating agencies
impact on prices of ratings changes
l
Ultimate question: how much should the compensate investors for bearing default risk
market
Abnormal stock price and bond price reaction to announcements by S&P that a firm’s bonds were being placed on Credit Watch for an anticipated action
Hand, Holthausen & Leftwich
Expected
# of events Indicated Downgrades 54
Unexpected
50
Unexpected and uncontaminated
26
Expected
Indicated Upgrades 16
Unexpected
8
Unexpected and uncontaminated
4
Bonds
Stocks
0.20% (0.57) -1.39 (-3.15) -1.79 (-2.31)
-0.36% (-0.76) -1.78 (-2.63) -2.14 (-1.84)
-2.12 (-2.22) 2.25 (1.53) 4.15 (1.76)
-0.13 (-0.21) -0.88 (-1.04) -0.22 (-0.43)
4 OUTCOMES FOR INVESTORS IN BONDS 1. Full payment of all coupons and principal through maturity
2. Issuer defaults Does bondholder lose all of initial investment? Coupons paid prior to default Recovery in bankruptcy
3. Exchange of new for old bonds
4. Issuer calls bonds depends on
movement in general level of interest rates change in creditworthiness of issuer
Relative likelihoods for high and low grade bonds Asquith’s evidence for junk bonds
cumulative default rate over the life of a bond vs likelihood of default in any individual year
EVALUATING THE RISK OF DEBT BY RATINGS CATEGORY Sources of risk: (i) risk due to illiquidity, (ii) risk due interest rate volatility, and (iii) risk of default
Consider risk in terms of a portfolio of bonds
Can evaluate relative contribution of second and third risks by looking at
RET t = β0 + β1 * TBt + β2 * SPt
where RET is the return on an index of bonds with default risk, TB is the return on an index of Treasury debt with comparable maturity, and SP is the return on the S&P 500.
TB measures the impact of interest rate changes on returns for corporate debt
SP measures the impact of overall market and economic conditions on the returns for corporate debt
For High-grade Debt - R2 is 0.83 for above equation β1 is about 0.8, β2 is about 0.1 R2 for TB alone is 0.8 vs R2 for SP alone is 0.15
For Low-grade Debt - R2 is 0.66 for above equation β1 is about 0.28, β2 is about 0.36 R2 for TB alone is 0.32 vs R2 for SP alone is 0.56