1. Credit Risk and the Value of Corporate Debt
Chapter 23
Principles of
Corporate
Finance
Tenth Edition
Credit Risk and the Value of Corporate Debt
Slides by
Matthew Will
McGraw Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved

2. Topics Covered Yields on Corporate Debt The Option To Default
Bond Ratings and the Probability of Default
Predicting the Probability of Default
Value at Risk

3. Valuing Risky Bonds Example A: Bond Value Prob 1,050 .80 = 840.00
We have a 5% 1 year bond. The bond is priced at par of $1000. But, there is a 20% chance the company will go into bankruptcy and only pay $500. What is the bond’s value?
A: Bond Value Prob
1, = =
= expected CF

4. Valuing Risky Bonds Example – Continued
Conversely - If on top of default risk, investors require an additional 3 percent market risk premium, the price and YTM is as follows:

5. Yield Spreads
Yield Spread, %

6. Credit Default Swap Data
Credit default swaps insure holders of corporate bonds against default. Dow Jones indexes of spreads on default swaps measure the annual insurance premium.
Spread, %

7. Key to Bond Ratings
The highest quality bonds are rated triple-A. Investment grade bonds have to be equivalent of Baa or higher. Bonds that don’t make this cut are called “high-yield” or “junk” bonds.

8. Bond Ratings and Financial Ratios
Three years of median ratio data by bond rating (2002– 2004).

9. Bond Ratings and Default
Default rates of corporate bonds by S&P’s rating at time of issue

10. Credit Analysis
Credit analysis is only worth while if the expected savings exceed the cost.
Don’t undertake a full credit analysis unless the order is big enough to justify it.
Undertake a full credit analysis for the doubtful orders only. 16

11. Asset Value and Default
The market value of WorldCom assets, as default approached
Value, $ millions
Default date

12. Value at Risk (VaR) Value at Risk = VaR Newer term
Attempts to measure risk
Risk defined as potential loss
Limited use to risk managers
Factors
Asset value
Daily Volatility
Days
Confidence interval

13. Value at Risk (VaR) Standard Measurements 10 days
99% confidence interval
VaR

14. Value at Risk (VaR)
Example You own a $10 mil portfolio of IBM bonds. IBM has a daily volatility of 2%. Calculate the VaR over a 10 day time period at a 99% confidence level.

15. Ratings Changes