Credit Risk Bond rating agencies Bond rating categories Moody’s Investor Service Standard & Poor’s Bought Canadian Bond Rating Services (CBRS) Fitch Dominion Bond Rating Services (DBRS) Canadian Bond rating categories Investment grade (BBB and above) Speculative grade (BB and below) ~ Junk bonds (Fallen angels: once investment grade, now junk) 7/21/2019
Bond Rating Process: New Issuer Initiation (by the issuer or its investment banker) Letter of engagement Gathering of information Meeting with management Draft report Rating committee Review by the issuer (factual accuracy/confidential info) Publishing Monitoring 7/21/2019
Financial Ratios by Rating Class 7/21/2019
Reuters yield spreads for Industrials (US) Source: Bondsonline Spread values represent basis points (bps) over a US Treasury security of the same maturity, or the closest matching maturity 7/21/2019
Predicting default: Altman’s Z-score A type of discriminant analysis Collect financial data for a sample of bankrupt firms one year prior to default Collect financial data for a sample of similar, but solvent firms Find a function of financial ratios (profitability, leverage, liquidity) that separates the bankrupt from the solvent firms Use this function to predict default 7/21/2019
Z-score: Graph 0.75 = 0.9 ROE + 0.4 Coverage ratio (0.75, 0.9, and 0.4 are estimates from the statistical analysis. 0.75 is called the critical level) 7/21/2019
Altman’s Estimates for Canadian Companies Predicting equation: Firms with Z > 1.626 were deemed “safe”, and firms with Z < 1.626 were “at risk of default” For U.S companies, there are online calculators 7/21/2019
Protection Against Default Can specify in the bond indenture: Sinking fund provisions Periodic payments made by bond issuer to reduce the amount of outstanding principal at maturity (via a trustee) Subordination of future debt Dividend restrictions Collateral Property mortgage bond Other securities held by the firm collateral trust bond Equipment equipment obligation bond 7/21/2019
Credit Risk and Yield Credit (default) risk premium Also called the “yield spread” Difference in YTM between a risky bond and a “safe” bond of the same term to maturity Should expect: low bond rating high YTM Yield spreads vary over the business cycles: flight to quality during recessions 7/21/2019
TED Spread Spread: 3-month LIBOR minus 3- month T-bill Default risk of interbank loans October 10, 2008 (465 bp) Source: Bloomberg 7/21/2019
Canadian Yields 2003-2013 7/21/2019
Canadian Corporate Spreads 2003-2013 7/21/2019
Overnight interest rates Federal funds rate Interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight Banks’ borrowing cost in the overnight lending market In 1995, the Feds began to explicitly state its target level for the federal funds rate Serves as the price target of monetary policy Overnight rate Canadian equivalent 7/21/2019
More Definitions Discount rate Overnight interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility 7/21/2019
How the LIBOR is set Source: New York Times 7/21/2019
What depends on the LIBOR? 7/21/2019