1. 05 – Default Risk

3. Junk Bonds Fallen Angels – bonds that were initially issued as investment grade that were subsequently diminished to junk Original Issue Junk: bonds issued with low credit rating  Lower on the priority scale of firm payments than “senior debt”

4. Default-Free Bond Example Face value = 1000 Price=900 YTM: 1000/900-1 = 11.11% Matures in 1 year Bond has no chance of default. Guaranteed to get $1000 at maturity. If you hold the bond to maturity, you earn 11.11% return.

5. Defaultable Bond Zero-coupon defaultable bond:  Face value: 1000  Matures in 1 year  Price=$800  YTM: 1000/800-1=25%  May default Suppose investors expect to get only $920 back  Expected YTM = 920/800-1=15%

6. Default Risk Premium Default risk premium (DRP) = ( YTM defaultable bond)-(YTM default free bond) In example - DRP=25.00%-11.11%=13.89% Why is the yield on low-grade bonds higher than that on default-free bonds? That is, why is the price of the junk bond lower than of the default-free bond?

7. Default Risk Premium Prices for low grade bonds are low, in part, because investors don’t expect to get all promised payments. 1000 900 11.11% Default-Free Bond 1000 Defaultable Bond 920 800 25% 15% Investors expect to get only 920 in payments. They expect to earn a yield of 15% YTM is always calculated using promised payments.

8. Expected Yield YTM: calculated using promised payments. Expected YTM: calculated using expected payments. In example, if YTM of the junk bond was 11.11%, price would be 900 and investors would expect to get a yield of only 920/900-1=2.22% Any reasonable investor should not hold low-grade bonds unless the expected yield is at least as high as that on default-free bonds.

9. Expected Yield Why is expected yield on low-grade bonds higher than on default-free bonds? 1000 900 11.11% Default-Free Bond 1000 Defaultable Bond 920 828.08 11.11% Why isn’t the price of the low grade bond 828.08? At this price, the expected yield from the low-grade bond is the same as on the default-free bond. 20.8%YTM That is, why isn’t the price of the low-grade bond 828.08?

10. Expected Yield Why is expected YTM on junk bonds higher? Because of the uncertainty regarding promised payments.  In example, the 920 expected payment is only a guess. In reality, the firm could end up paying a lot more or a lot less.

11. Expected Yield In general, riskier financial assets are priced so that, on average they are expected to give higher returns.  Small Stock vs. Large Stocks Any kind of uncertainty that causes returns, on average, to be higher is called systematic risk.

12. Default Risk Systematic Default Risk: The uncertainty surrounding payments investors will actually receive on a low-grade bond. Because of systematic default risk, the expected (average) yield on low grade bonds is higher than the yield on default- free bonds.

13. Systematic Default Risk Premium Systematic Default risk premium = (Expected YTM defaultable bond)-(YTM default free bond) In example, SDRP=15.00%-11.11% = 3.89% This spread is determined by  The level of uncertainty  How investors feel about this uncertainty

14. Systematic Default Risk Premium Comparing across bonds, as uncertainty surrounding the expected payments increases SDRP increases. Across time, as investors feel “more queasy” about bearing this risk, SDRP increases for all bonds.

16. Bond Yields

17. Yields and Financial Crises The default risk premium increases substantially during times of financial crises. Why? 1) Greater probability of default Investors expect to get less, and accordingly, prices drop. 2) There is greater uncertainty surrounding the expected payments. The systematic default risk premium increases leading to further drop in price and an even greater default risk premium. 3) Flight to quality During crises, investors flee to the safety of default free bonds, causing the yields of such bonds to decrease leading to an even greater default risk premium.

18. Yields and Financial Crises Illustration of points 1, 2, and 3 from previous slide 1000 900 11.11% Default-Free Bond 1000 Defaultable Bond 920 800 25% 15% DRP=25-11.11=13.89

19. Yields and Financial Crises Illustration of points 1, 2, and 3 from previous slide 1000 Default-Free Bond 1000 Defaultable Bond 850 730 Expected payment drops due to higher probability of default (point 1) Systematic default risk premium increases due to greater uncertainty (point 2) 16.4% 37% 920 8.7% Relative risk of default free bonds drops. Demand curve Shifts right. Yields decrease (point 3) DRP=37-8.7=28.3

20. Source: Altman, “Defaulted Bond and Bank Loan Markets and Outlook” (2004)

21. Example YTM on default-free bond: 8% YTM on junk bond: 33.33% Expected YTM on junk bond: 12% Assuming these are both zero-coupon bonds that mature in 1 year, what is expected payment on junk?

22. Example.333=1000/price-1 Price=1000/1.333=750 E[payment]/750-1=0.12 E[payment]=750*1.12=840 Suppose financial distress strikes and the market expects the junk bond to pay only 600 at year- end. Accordingly, the price drops to 530. What is YTM? What is E[YTM]?

23. Example YTM of junk bond is 1000/530-1=87% Expected YTM = 600/530-1=13.21% What is the default risk premium before and after the financial crisis hit? Assume the crises caused the YTM of the default-free bond to fall to 7%.  Before: 33.33% - 8.00% = 25.33  After: 87%-7% = 80%

24. Example What is the difference in expected yields before and after the crisis? Assume the crises caused the YTM of the default-free bond to fall to 7%.  Before: 12%-8%=4%  After: 13.21%-7%=5.21%