Credit Risk Analysis

What is a bond? A long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond. Creditors receive interest and principal payments they have been promised

What determines interest rates of corporate bonds? ki = k* + IP + MRP +DRP + LP ki = required return on a debt security k* = real risk-free rate of interest IP = inflation premium MRP = maturity risk premium (also called interest rate risk premium) DRP = default risk premium LP = liquidity premium

Default risk If an issuer defaults, investors receive less than the promised return. Therefore, the expected return on corporate bonds might be less than the promised return. Default risk is influenced by the issuer’s financial strength and the terms of the bond contract.

Default Risk A bond also has legal rights attached to it: if the borrower doesn’t make the required payments, bondholders can force bankruptcy proceedings in the event of bankruptcy, bond holders get paid before equity holders

Bankruptcy Two main chapters of the Federal Bankruptcy Act: Chapter 11, Reorganization Chapter 7, Liquidation Chapter 11 bankruptcy is a financial reorganization in which the company continues to operate and works with creditors to formulate repayment plans. Chapter 7 bankruptcy is a complete liquidation in which the firm ceases operations and sells all assets. Typically, a company wants Chapter 11, while creditors may prefer Chapter 7.

Credit rating Rely on qualitative and quantitative analyses Standard & Poor’s (AAA to D) Intermediate “+/-” scores Moody’s (Aaa to C) Intermediate “1,2,3” scores Fitch (AAA to D)

Rating Criteria Bond Quality Ratings Rating Grades Standard & Poor’s Moody’s Highest grade AAA Aaa High grade AA Aa Upper medium A A Lower medium BBB Baa Marginally speculative BB Ba Highly speculative B B, Caa Default D Ca, C 2 2

Now more competition! Of the more than 130 credit-rating agencies, the SEC has granted only five the designation NRSROs: Moody's, S&P, A.M. Best, Dominion Bond Rating Service, and Fitch Ratings. President Bush Signs Rating Agency Reform Act on October 2006 A credit-rating company with three years of experience that meets certain standards would be allowed to register with the SEC as a “nationally recognized statistical ratings organization (NRSRO)."

Rating Debt Obligations Source: Standard & Poor’s, 2002 Ratings and Yields Source: Standard & Poor’s, 2002 2 2

Factors affecting default risk and bond ratings Financial performance Debt ratio Current ratio Other ratios Be aware of accounting distortions Bond contract provisions Secured vs. Unsecured debt Senior vs. subordinated debt Guarantee Debt maturity

Standard & Poor’s rating method EBIT interest coverage EBITDA interest coverage Funds from operations/Total debt % Free operating cash flow/Total debt % Return on capital % Operating income/Sales Long-term debt/Capital Total debt/Capital

Financial distress Financial distress can also be directly predicted.

Prediction of bankruptcy Bankruptcy prediction models are used in the same way as the bond ratings prediction models. Dependent variable is a dummy variable indicating whether or not the firm went bankrupt. Beaver (1966) investigated the use of financial ratios in the bankruptcy prediction. The results clearly indicate that values of the financial ratios differ between failed and non-failed firms.

Prediction of financial distress Univariate models Beaver (1966) relied on Cash flow to total debt Net income to total assets Total debt to total assets Working capital to total assets Current ratio

Example: Cash flow / total debt

Example (cont.): Net income / total assets

Example (cont.): Total debt / total assets

Example (cont.): Working capital / total assets

Example (cont.): Current ratio

Predicting Financial Distress Altman Z-Score X1 = Working capital/Total assets X2 = Retained earnings/Total assets X3 = Earnings before interest and taxes/Total assets X4 = Shareholders’ market value/Total liabilities X5 = Sales/Total assets Z<1.81 implies a high probability of bankruptcy Z>2.99 implies a low probability of bankruptcy 1.81<Z<2.99 implies an ambiguous area 2 2

Prediction of financial distress Multivariate models Altman Z-score (Current assets – current liabilities)/total assets Retained earnings/Total assets EBIT/Total assets Preferred and common stock market value/Book value of liabilities Sales/Total assets Nokia = 9.88 Motorola = 1.71 (below the 2.99 nonbankrupt benchmark)

Motorola, Note 8 Off-balance-sheet financing “At December 31, 2001, future minimum lease obligations, net of minimum sublease rentals, for the next five years and beyond are as follows: 2002—$150 million; 2003—$117 million; 2004—$97 million; 2005—$76 million; 2006—$63 million; beyond—$90 million.” The present value of these payments, at 7%, is $484 million Inclusion of these items increases debt by 5%

Nokia debt note detail Operating lease payments

Elements of Free Operating Cash Flow 2001 Nokia (EURm) Motorola ($m) EBITDA 5,735 (4,039) Non-cash items 248 (2,273) Fund from operations 5,983 (6,312) Capital expenditures (1,041) (1,321) Working capital change 978 1,527 Free operating cash flow 5,920 (6,106)

Debt Analysis Ratios

More Recent Advances in Distress Prediction RiskCalc Market (Merton) Model

RiskCalc™ “The model's key advantage derives from Moody's unique and proprietary middle market private firm financial statement and default database (Credit Research Database), which comprises 28,104 companies and 1,604 defaults. Our main insights and conclusions are: … Comprehensive testing and validation suggest that RiskCalc's predictive power is superior to that of other publicly available benchmark models and is robust across non-financial industry sectors, and over time. RiskCalc™ was developed to achieve maximum predictive power with the smallest number of inputs. It requires just 10 financial ratios & indicators computed from 17 basic financial inputs. RiskCalc's predictive power derives, in part, from its meticulous transformation of input financial ratios….” Source: RiskCalc™ For Private Companies: Moody's Default Model , may 2000

Transforming raw ratios

From Raw Data to Ratios

Contribution of Factors

Market Model (Not required) Banks can use the theory of option pricing to assess the credit risk of a corporate borrower The probability of default is positively related to: the volatility of the firm’s stock the firm’s leverage A model developed by KMV corporation is being widely used by banks for this purpose