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10-1 Chapter 10 Default Risk. 10-2 zEvery bond issue has a contract called the bond indenture among three parties – the bondholders, the issuer, and the.

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Presentation on theme: "10-1 Chapter 10 Default Risk. 10-2 zEvery bond issue has a contract called the bond indenture among three parties – the bondholders, the issuer, and the."— Presentation transcript:

1 10-1 Chapter 10 Default Risk

2 10-2 zEvery bond issue has a contract called the bond indenture among three parties – the bondholders, the issuer, and the trustee. zThe trustee is appointed to protect the interests of the bondholders and must be independent of the issuing firm. Bond Indenture

3 10-3 zCorporate bond issues have protective covenants. These are restrictions on the issuer to prevent the issuer from taking advantage of the bondholders. zTypical protective covenants include restrictions on yIssuance of additional debt. yDividends. yMergers. yDisposition of assets. Protective Covenants

4 10-4 zDefault is a violation of any part of the bond indenture agreement. zSome defaults involved nonpayment of interest or principal. zOther defaults involve violation of some protective covenant in the bond indenture. Default

5 10-5 zThe trustee acts on behalf of the bondholders in the event of default. If there is a nonpayment of cash, 100 percent agreement of the bondholders is required for the trustee to take action. For other defaults, complete agreement of the bondholders is not necessary for the trustee to act.

6 10-6 Default Renegotiate Bankruptcy Reorganize Liquidate

7 10-7 Fishermen acting individually$100,000 now Fishermen acting in concert$25,000 annually Common Pool Problem

8 10-8 zCourt costs. zAttorneys fees. zLost profit opportunities. Who would lend money to or buy products from firms in bankruptcy? Costs of Bankruptcy

9 10-9 zFinancial distress is defined as a condition in which operating income is less than fixed charges payable to creditors. zA firm in financial distress may request protection of the bankruptcy court. Financial Distress

10 10-10 zHowever, some firms in financial distress may consider other courses of action. ySale of assets. yRaise equity. yMerge. yBorrow more. Reschedule old loans. yUse depreciation. yGovernment assistance.

11 10-11 zAccording to the rule of absolute priority, claimants are paid in the following order. Each category must be paid in full before the next can receive any payments. zCourts, tax obligations, employees, secured creditors, unsecured creditors, preferred stockholders, equity stockholders. Rule of Absolute Priority

12 10-12 zThe rule of absolute priority applies in liquidations, which represent about 10 percent of corporate bankruptcies. zIn reorganizations, which represent probably 90 percent of corporate bankruptcies, the rule of absolute priority is not followed.

13 10-13 zIn a reorganization, the bankruptcy courts have set up a complicated set of procedures for trying to arrive at a reorganization. Stockholders have the first chance to present a reorganization plan, followed by creditors. If the parties cannot agree, the bankruptcy court has the right to impose a reorganization plan. Reorganization Procedures

14 10-14 zWhile a firm is in bankruptcy, the firm’s securities typically continue to trade, although there may be some interruptions of trading. Investing in either the bonds or the stocks of firms in bankruptcy is extremely risky. The returns can be very poor or very good.

15 10-15 zDebentures are bonds which have a general claim on the assets of a firm. There may be priorities of claims, such as junior and senior or subordinated and unsubordinated. zMortgage bonds are secured bonds, which have the first claim on a specific asset. zIncome bonds arise out of bankruptcies. Important Terms

16 10-16 zBecause there are so many corporate bonds outstanding and each issue has special characteristics, rating agencies have developed to provide information to investors about to the likelihood of default. zThe three largest rating agencies are Moody’s, Standard & Poor’s, and Fitch. Bond Ratings

17 10-17 Bond Ratings Moody’sFitch and S&PInterpretation AaaAAA highest quality Aa1AA+ Aa2AAHigh Quality Aa3AA- A1A+Strong Payment A2ACapacity A3A- Baa1BBB+Adequate Payment Baa2BBBCapacity Baa3BBB-

18 10-18 Bond Ratings Ba1BB+Likely to fulfill Ba2BBobligations; ongoing Ba3BB-Uncertainty B1B+ B2BHigh Risk Obligations B3B- CCC+Current vulnerability CaaCCCto default CCC- CaCCIn bankruptcy or CCdefault or other DDmarked shortcomings

19 10-19 Treasury Spread Bond Yield Yield on Comparable Maturity Treasury Security (Default-Free) = –. Treasury Spread Bond Rating 4% 2% 1% AAAAAABBBBBB 3%

20 10-20 Underwriter Spread Bond Rating 4% 2%.75% AAAAAABBBBBB 3%

21 10-21 Factors Determining Bond Ratings zWhile the rating agencies do not follow a simple formula in determining ratings, the following factors have been found to be statistically important determinants of ratings.

22 10-22 zA bond will tend to have a higher rating if the following are true: yThe firm has lower debt ratios (debt/assets, debt/equity). yThe firm has higher interest coverage ratios (earnings before interest and taxes divided by interest). yThe firm has higher rates of return of assets (profit/assets, profit/equity). yThe firm has lower relative variation in earnings over time. yThe firm is of larger size. yThe bond issue is unsubordinated.

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