1. 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)
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2. 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
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3. Financial Ratios by Rating Class
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4. 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
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5. 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
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6. 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 is called the critical level)
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7. Altman’s Estimates for Canadian Companies
Predicting equation:
Firms with Z > were deemed “safe”, and firms with
Z < were “at risk of default”
For U.S companies, there are online calculators
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8. 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
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9. 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
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10. TED Spread Spread: 3-month LIBOR minus 3- month T-bill
Default risk of interbank loans
October 10, (465 bp)
Source: Bloomberg
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11. Canadian Yields
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12. Canadian Corporate Spreads 2003-2013
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13. 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
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14. 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
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15. How the LIBOR is set
Source: New York Times
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16. What depends on the LIBOR?
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