DEBT MORTALITYMARKOV ANALYSIS OF MOODY’S CREDIT RATINGS

Final Project

MAC5116 - Stochastic Processes

Summer 2010

Kevin McLaughlin

OUTLINE

Balance Sheet 101

Credit Ratings

Markov Analysis

Moody’s Migration Table

Investment Quality

Canonical Form for Migration Table

Fundamental Matrix

Time Spent in Transient States

Probability of Transition and Absorption

Case Studies

Discussion

Appendix

BALANCE SHEET 101

At it’s core, a business can be described by a few basic components

Assets

Tangible items like property, plant, and equipment

Intangibles like patents, copyrights, and branding

Liabilities

Current (due in 12 mo), money to suppliers, payroll, …

Long term Debt (Bonds, convertibles, & commercial paper)

Shareholder’s Equity

Equity = Assets – Liabilities

What’s left of the assets after paying all liabilities

Assets of a company can be funded by debt OR equity

CREDIT RATINGS

Few people realize the global equity, or stock, market

is dwarfed by the bond market

Outstanding bond debt totaled roughly $82 trillion in 2008,

v. about $40 trillion in the stock markets

Companies can survive large drops in equity, but they

generally don’t survive very long when they default

(miss payments) on their bond debts, file for

bankruptcy, or renegotiate loan terms

Ratings agencies like Standard & Poor’s, Moody’s,

and Fitch provide convenient and useful measures of

a company’s financial health

MOODY’S RATING - THE SOUTHERN CO.

The Southern Company, parent of Gulf Power, is rated A3,

which is great, but it looks like they may get downgraded

MARKOV ANALYSIS

MOODY’S LETTER RATINGS

Below is a one-year migration table for Moody’s ratings

Can be further distinguished with numbers (22 in total)

Notice:

Dominance of the diagonal

Heavy weighting to the right of the diagonal

Absorbing states, Default and Withdrawn Rating

Equivalent to financial death

Average One-Year Letter Rating Migration Rates, 1970-2008

From/To Aaa Aa A Baa Ba B Caa Ca-C Default WR

Aaa 88.495 7.618 0.650 0.026 0.028 0.002 0.002 0.000 0.000 3.179

Aa 1.047 86.817 7.077 0.288 0.042 0.016 0.008 0.001 0.016 4.688

A 0.066 2.832 87.274 4.961 0.473 0.086 0.028 0.003 0.024 4.253

Baa 0.043 0.191 4.786 84.382 4.165 0.781 0.203 0.021 0.163 5.265

Ba 0.008 0.056 0.395 5.678 76.054 7.070 0.549 0.061 1.084 9.045

B 0.011 0.037 0.133 0.346 5.034 73.940 5.090 0.620 4.165 10.624

Caa 0.000 0.026 0.037 0.222 0.484 8.928 60.782 3.589 13.122 12.810

Ca-C 0.000 0.000 0.000 0.000 0.331 2.790 9.446 39.479 30.033 17.921

Default 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 100.000 0.000

WR 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 100.000

INVESTMENT QUALITY

Total space of Letter Ratings

These ratings can be partitioned into three levels of

investment quality

Investment Grade

Most mutual funds and other retirement-oriented funds are

only allowed to buy investment grade bonds

High Yield (Speculative or Junk)

Only aggressive investors buy this type of debt

Most likely to be mispriced due to market inefficiencies

Default or Withdrawn Rating

CCaCaa,B,Ba,HY,BaaA,Aa,Aaa,IG

WRDefault,C,CaCaa,B,Ba,Baa,A,Aa,Aaa,S

CANONICAL FORM FOR MIGRATION TABLE

Transient block

39.4799.4462.7900.3310.0000.0000.0000.000

3.58960.7828.9280.4840.2220.0370.0260.000

0.6205.09073.9405.0340.3460.1330.0370.011

1.0610.5497.07076.0545.6780.3950.0560.008

0.0210.2030.7814.16584.3824.7860.1910.043

0.0030.0280.0860.4734.96187.2742.8320.066

0.0010.0080.0160.0420.2887.07786.8171.047

0.0000.0020.0020.0280.0260.6507.61888.495

CCa

Caa

B

Ba

Baa

A

Aa

Aaa

CCa Caa B Ba Baa A Aa AaaQ

Recurrent block

17.92130.033

12.81013.122

10.6244.165

9.0451.084

5.2650.163

4.2530.024

4.6880.016

3.1790.000

CCa

Caa

B

Ba

Baa

A

Aa

Aaa

WRDefault R

FUNDAMENTAL MATRIX (I-Q)-1

1.6830.4560.3720.1250.0750.0460.0150.002

0.1732.7331.0490.3200.2240.1390.0470.007

0.0820.6034.3551.0420.6050.3740.1190.020

0.0380.2851.5034.9062.2061.1920.3430.051

0.0230.1750.7771.6758.2353.7301.0150.146

0.0140.1040.4560.9843.83910.7742.5550.310

0.0090.0670.2900.6202.3946.2479.4910.909

0.0070.0520.2240.4821.8264.7576.4329.312

CCa

Caa

B

Ba

Baa

A

Aa

Aaa

CCa Caa B Ba Baa A Aa AaaQ)-(I -1

8

1j

1-

ijQ)-(I

Entry is the expected number of visits to transient state

j before the process reaches an absorbing state

is the expected number of steps before absorption

1-ij

Q)-(I

TIME SPENT IN TRANSIENT STATES

Companies rated Aaa are expected to remain so for

9.312 years, while they can be expected to spend

0.482 years as speculative Ba

Notice the dominance of the diagonal

Tendency to remain at current rating

1.6830.4560.3720.1250.0750.0460.0150.002

0.1732.7331.0490.3200.2240.1390.0470.007

0.0820.6034.3551.0420.6050.3740.1190.020

0.0380.2851.5034.9062.2061.1920.3430.051

0.0230.1750.7771.6758.2353.7301.0150.146

0.0140.1040.4560.9843.83910.7742.5550.310

0.0090.0670.2900.6202.3946.2479.4910.909

0.0070.0520.2240.4821.8264.7576.4329.312

CCa

Caa

B

Ba

Baa

A

Aa

Aaa

CCa Caa B Ba Baa A Aa AaaQ)-(I -1

TIME UNTIL ABSORPTION

Row sum equals the expected number of years spent as Investment Grade and High Yield entities

After that, the only remaining states are Default and Withdrawn Rating

The better the current rating, the longer you can expect a company’s debt to provide you with income It seems reasonable to invest in Investment Grade debt

with 15-20 year maturities. Similarly, you probably shouldn’t invest in High Yield debt with maturities greater than 10 years

,

CCa

Caa

B

Ba

Baa

A

Aa

Aaa

CCa Caa B Ba Baa A Aa AaaQ)-(I -1

1.6830.4560.3720.1250.0750.0460.0150.002

0.1732.7331.0490.3200.2240.1390.0470.007

0.0820.6034.3551.0420.6050.3740.1190.020

0.0380.2851.5034.9062.2061.1920.3430.051

0.0230.1750.7771.6758.2353.7301.0150.146

0.0140.1040.4560.9843.83910.7742.5550.310

0.0090.0670.2900.6202.3946.2479.4910.909

0.0070.0520.2240.4821.8264.7576.4329.312

2.774

4.693

7.198

10.525

15.776

19.036

20.028

23.092

CCa

Caa

B

Ba

Baa

A

Aa

Aaa

Years

PROBABILITY OF TRANSIENT STATE J

The off-diagonal entries represent the probability

of EVER going from rating i to j

Diagonal entries represent the probability of

returning to rating i given that it started with

rating i

Let F = (I-Q)-1, => (F-I) X diag(F)-1

,

CCa

Caa

B

Ba

Baa

A

Aa

Aaa

CCa Caa B Ba Baa A Aa Aaa)Q)-diag((II)-Q)-((I -1-1-1

40.59416.6828.5592.5430.9090.4220.1550.025

10.29263.41624.0906.5202.7151.2940.4950.077

4.85022.05477.03621.2297.3433.4711.2490.216

2.26310.43734.51979.61826.78911.0633.6160.549

1.3726.41417.83834.14387.85734.61610.6911.572

0.8183.82010.47920.04846.61890.71826.9173.327

0.5282.4646.67112.63729.06857.98689.4649.764

0.4071.9095.1559.82622.17444.15167.76989.261

ABSORPTION PROBABILITIES

The probability of being downgraded to one of the two absorbing ratings, given the transient rating on the left

Row sums equal unity

Withdrawal of rating is the most likely scenario Considered a neutral way of retiring debt

Default risk is drastically more significant for High Yield rated debt Debt default is negative for all parties and loss of

investment ensues

41.76058.240

54.17245.828

70.26329.737

83.14016.860

90.5069.494

94.3255.675

96.2753.725

97.1372.863

CCa

Caa

B

Ba

Baa

A

Aa

Aaa

WRDefault RQ)-(I -1

CASE STUDIES

BERKSHIRE HATHAWAY INC. Run by Warren Buffet, CEO & Chairman, and

Charlie Munger, Vice Chairman

Initially rated Aaa in June of 2001 on $700 million of shelf debt, which was later used to finance the purchase of Executive Jet Inc. (NetJets®)

Long-term debt rated Aaa in April 2006

Recently downgraded to Aa in April 2009

Buffet’s age, 79, was significant to rating action

89.3% chance of ever regaining Aaa rating

3.7% chance of defaulting

Outstanding debt expected to last 20 years

Longest dated debt, $1.7B @ 3.2%, matures in 2015

GULF POWER COMPANY

Current Rating is A (since at least 1995)

On watch for potential downgrade, as well as Georgia Power Co., and Mississippi Power Co.

Lower revenues due to the recession (Surprise!)

Lower revenues due to economic impact of BP oil spill

High Capital Expenditures for environmental compliance over the next several years

FL regulators have not allowed utilities to charge customers rates that produce expected returns

90.7% chance of regaining A rating if downgraded

5.7% chance of defaulting

Outstanding debt expected to last 19 years

Longest dated debt, $35M @ 5.875%, in 2044

NEW ALBERTSON’S, INC. My first employer (W. 9 Mile & Pine Forest Rd)

Current Rating is Ba Aa in May 1992

Withdrawn rating in May 1995

Aa in Jun 1995

A in Mar 1999, downgrade

Baa in Jan 2001, downgrade

Ba in April 2006, downgrade

B in May 2006, downgrade

Ba Jan 2009, upgrade

High Yield (Junk) status

16.9% chance of defaulting

Outstanding debt expected to last 10.5 years (or 7.2 years to be conservative)

Longest dated debt, $225M @ 8.7%, in 2030

BRITISH PETROLEUM P.L.C.

Recently downgraded to A from Aa

A in May 1995

Aa in Nov 1995, upgrade

A in Jun 2010, downgrade

Still Investment Grade

Risk of default increased to 5.7% from 3.7%

Outstanding debt expected to last 19 years

Initially rated as A. The probability of ever being

upgraded to Aa was 27%. Probability of returning

to A was 91%. 47% chance of Baa rating (still

investment grade)

DISCUSSION

Two important safety criteria for debt investors are time

horizon and low default risk. Markov analysis shows the

usefulness of Moody’s rating system for categorizing

investments by these two criteria

Considering the expected time-to-absorption for

Investment Grade debt is longer than 15 years, it makes

sense for retirement oriented investment funds to stick

with these types of debt securities

Similarly, due to their relatively short life spans, and

high default rates, High Yield investments SHOULD be

limited to more discretionary funds with greater

appetite for risk

APPENDIX

PROFILE OF NEW DEBT ISSUERS

Issuers by Debt Rating Issuers By IG

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

19

70

19

75

19

80

19

85

19

90

19

95

20

00

20

05

Aaa Aa ABaa Ba B

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

19

70

19

75

19

80

19

85

19

90

19

95

20

00

20

05

Invest Grade Spec Grade

REASONS FOR DEFAULT

Moody’s definition of default includes three types of credit events A missed or delayed disbursement of interest and/or

principal

Bankruptcy, administration, legal receivership, or other legal blocks (perhaps by regulators) to the timely payment of interest and/or principal

A distressed exchange occurs where: (i) the issuer offers debt holders a new security or package of securities that amount to a diminished financial obligation (such as preferred or common stock, or debt with a lower coupon or par amount, lower seniority, or longer maturity); and (ii) the exchange has the effect of allowing the issuer to avoid a bankruptcy or payment default

Taken from “Corporate Default and Recovery Rates, 1920-2008,” February 2009

REASONS FOR WITHDRAWAL OF RATINGS A withdrawn rating signifies the removal of a rating on either an obligation or an

issuer. Withdrawn ratings reflect Moody's current view of the credit at the time of withdrawal

Inadequate information Any rating may be withdrawn if, in Moody's opinion, there is insufficient information to

assess effectively the creditworthiness of the issuer or obligation. This would typically hold in situations where the issuer declines to provide information requested by Moody's and Moody's cannot otherwise attain the requested information through public channels

Bankruptcy/Reorganization/Liquidation If the issuer defaults, enters bankruptcy/reorganization or is liquidated, it may no longer

be useful or necessary for Moody's to maintain a rating on the issuer or the issuer's obligations

Business Reasons Under certain circumstances, Moody's will withdraw a rating for an issuer or an

obligation for reasons unrelated to the adequacy of information, or bankruptcy or reorganization status of the credit. When this occurs, Moody's will balance the market need for a rating against the resources required to maintain and monitor a rating

Maturity of obligation An obligation rating will be withdrawn when the rated obligation is no longer

outstanding. In practice, the vast majority of WR actions arise from routine debt maturities, calls, or redemptions

Taken from “Moody’s Guidelines for the Withdrawal of Ratings.” January 2004