Chapter( 7 B) Default Risk Salwa Elshorafa 2009 © 2005 Pearson Education Canada Inc.

3-2 Introduction Person whoi borrow money are not always able to repay their loans. Individual borrowers may lose job, firms may lose customers, and state and local government may lose their tax base.only the U.S. Treasury is absolutely certain of always having enough money to repay its debt – because the federal government can literally print money.

© 2005 Pearson Education Canada Inc. 3-3 In this chapter we will look at how banks and other lender evaluate the credit – worthiness of potential borrowers and at how market price and interest rate reflect this assessment.you will see how bonds are rated and why bonds with low ratings have high yield to maturity. An extreme example is junk bonds ( bonds that have the lowest rating or aren't rated at all. Introduction

© 2005 Pearson Education Canada Inc. 3-4 Bonds Borrower default when they don’t pay what was promised at the time they promised to pay it. Historically,bond defaults have been relatively infrequent, because likely defaulters haven't been able to borrow much. The ideal borrower has profitable plans for the borrowed money but doesn't need cash to stay afloat.

© 2005 Pearson Education Canada Inc. 3-5 Bonds Investors have shown an increasing willingness to buy high risk bonds (junk debt ) issued by business and state and local government agencies with acknowledge financial problems

© 2005 Pearson Education Canada Inc. 3-6 Bond Rating To evaluate the creditworthiness of debt issuers, considerable amount of information must be gathered,processed and analyzed carefully. Some large institutions investors have their owe internal staff that specialize in evaluating the merits of bonds issuers. Many bonds are rated by Moody's and standard and Poor's

© 2005 Pearson Education Canada Inc. 3-7 Bond Rating U.s. Treasury securities are not rated, because the chance of default are negligible Corporate and state and local government bonds as many investors have learned painfully can and occasionally do default

© 2005 Pearson Education Canada Inc. 3-8 Bond Rating categories Moody'sStandard & Poor's Rating Assessment Rating Assessment Aaa Best quality AAA Highest rating Aa High quality AA Very strong A Upper medium grade A Strong Baa Medium grade BBB Adequate B Lack characteristic of desirable investment B Speculative Caa Poor standing may be in default CCC-CC Highly speculative Ca Speculative ( …..) C Income bonds with no interest paid C Lowest rate class D In default

© 2005 Pearson Education Canada Inc. 3-9 Financial Ratios and Bond Rating How Moody's and standard &Poor's determine the appropriate rating for a company's bonds? They conduct quantitative evaluation of its current and past financial condition and make a subject assessment of the firms future

© 2005 Pearson Education Canada Inc The relevant question is “ Will this firm have enough profits and enough cash flow” to meet the mandated payments on its debts?” Among the data examined are the four financial ratio Financial ratio are used to help rate bond Financial Ratios and Bond Rating

© 2005 Pearson Education Canada Inc )The pre-tax fixed –charge coverage ratio is the ratio of profit ( before taxes and interest payments) to bond payment, lease payment,nondiscretionary expenses…) 2)Cash flow to total debt * cash flow measure the money actually coming into the firm, and the ratio of cash flow to debt. * the most highly rated firms have both high profit. Financial Ratios and Bond Rating

© 2005 Pearson Education Canada Inc ) The pre-tax return on long term (percent ) capital is a measure of the firms basic profitability 4) Long – term debt to capitalization : is the ratio of the firms long – term debt to the sum of its short- term debt, long term debt and stock –essentially the total value of the firms, because those who own its debt and stock receive all of the money (interest and dividend) paid out by the firm Financial Ratios and Bond Rating

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© 2005 Pearson Education Canada Inc Risk and promised return

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