Chapter( 7 B)

Default Risk

Salwa Elshorafa2009

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Introduction

• Person whoi borrow money are not always able to repay

their loans . Individual borrowers may lose job , firms may

lose customers , and state and local government may lose

their tax base .only the U.S. Treasury is absolutely certain

of always having enough money to repay its debt – because

the federal government can literally print money.

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• In this chapter we will look at how banks and other lender

evaluate the credit – worthiness of potential borrowers and

at how market price and interest rate reflect this

assessment .you will see how bonds are rated and why

bonds with low ratings have high yield to maturity . An

extreme example is junk bonds ( bonds that have the

lowest rating or aren't rated at all.

Introduction

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Bonds

• Borrower default when they don’t pay what was promised

at the time they promised to pay it .

• Historically ,bond defaults have been relatively

infrequent , because likely defaulters haven't been able to

borrow much . The ideal borrower has profitable plans for

the borrowed money but doesn't need cash to stay afloat .

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Bonds

• Investors have shown an increasing willingness to

buy high risk bonds (junk debt ) issued by

business and state and local government agencies

with acknowledge financial problems

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Bond Rating

• To evaluate the creditworthiness of debt issuers ,

considerable amount of information must be

gathered ,processed and analyzed carefully . Some large

institutions investors have their owe internal staff that

specialize in evaluating the merits of bonds issuers.

• Many bonds are rated by Moody's and standard and Poor's

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Bond Rating

• U.s. Treasury securities are not rated , because the chance

of default are negligible

• Corporate and state and local government bonds as many

investors have learned painfully can and occasionally do

default

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Bond Rating categories

Moody's Standard & Poor's Rating Assessment Rating Assessment

Aaa Best quality AAA Highest rating

Aa High quality AA Very strong

A Upper medium grade A Strong

Baa Medium grade BBB Adequate

B Lack characteristic of desirable investment

B Speculative

Caa Poor standing may be in default

CCC-CC Highly speculative

Ca Speculative ( …..) C Income bonds with no interest paid

C Lowest rate class D In default

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Financial Ratios and Bond Rating

• How Moody's and standard &Poor's determine the

appropriate rating for a company's bonds?

• They conduct quantitative evaluation of its current and

past financial condition and make a subject assessment of

the firms future

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• The relevant question is “ Will this firm have enough

profits and enough cash flow” to meet the mandated

payments on its debts?”

• Among the data examined are the four financial ratio

• Financial ratio are used to help rate bond

Financial Ratios and Bond Rating

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1) The pre-tax fixed –charge coverage ratio is the ratio of

profit ( before taxes and interest payments) to bond

payment , lease payment ,nondiscretionary expenses…)

2) Cash flow to total debt

* cash flow measure the money actually coming into the

firm , and the ratio of cash flow to debt.

* the most highly rated firms have both high profit .

Financial Ratios and Bond Rating

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• 3) The pre-tax return on long term (percent ) capital is a

measure of the firms basic profitability

• 4) Long – term debt to capitalization : is the ratio of the

firms long – term debt to the sum of its short- term debt ,

long term debt and stock –essentially the total value of the

firms , because those who own its debt and stock receive

all of the money (interest and dividend) paid out by the

firm

Financial Ratios and Bond Rating

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Risk and promised return

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