1. Credit Risk Analysis

2. What is a bond?
A long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond.
Creditors receive interest and principal payments they have been promised

3. What determines interest rates of corporate bonds?
ki = k* + IP + MRP +DRP + LP
ki = required return on a debt security
k* = real risk-free rate of interest
IP = inflation premium
MRP = maturity risk premium (also called interest rate risk premium)
DRP = default risk premium
LP = liquidity premium

4. Default risk
If an issuer defaults, investors receive less than the promised return. Therefore, the expected return on corporate bonds might be less than the promised return.
Default risk is influenced by the issuer’s financial strength and the terms of the bond contract.

5. Default Risk A bond also has legal rights attached to it:
if the borrower doesn’t make the required payments, bondholders can force bankruptcy proceedings
in the event of bankruptcy, bond holders get paid before equity holders

6. Bankruptcy Two main chapters of the Federal Bankruptcy Act:
Chapter 11, Reorganization
Chapter 7, Liquidation
Chapter 11 bankruptcy is a financial reorganization in which the company continues to operate and works with creditors to formulate repayment plans.
Chapter 7 bankruptcy is a complete liquidation in which the firm ceases operations and sells all assets.
Typically, a company wants Chapter 11, while creditors may prefer Chapter 7.

7. Credit rating Rely on qualitative and quantitative analyses
Standard & Poor’s (AAA to D)
Intermediate “+/-” scores
Moody’s (Aaa to C)
Intermediate “1,2,3” scores
Fitch (AAA to D)

8. Rating Criteria Bond Quality Ratings
Rating Grades Standard & Poor’s Moody’s
Highest grade AAA Aaa
High grade AA Aa
Upper medium A A
Lower medium BBB Baa
Marginally speculative BB Ba
Highly speculative B B, Caa
Default D Ca, C 2 2

9. Now more competition!
Of the more than 130 credit-rating agencies, the SEC has granted only five the designation NRSROs: Moody's, S&P, A.M. Best, Dominion Bond Rating Service, and Fitch Ratings.
President Bush Signs Rating Agency Reform Act on October 2006
A credit-rating company with three years of experience that meets certain standards would be allowed to register with the SEC as a “nationally recognized statistical ratings organization (NRSRO)."

10. Rating Debt Obligations Source: Standard & Poor’s, 2002
Ratings and Yields
Source: Standard & Poor’s, 2002 2 2

11. Factors affecting default risk and bond ratings
Financial performance
Debt ratio
Current ratio
Other ratios
Be aware of accounting distortions
Bond contract provisions
Secured vs. Unsecured debt
Senior vs. subordinated debt
Guarantee
Debt maturity

12. Standard & Poor’s rating method
EBIT interest coverage
EBITDA interest coverage
Funds from operations/Total debt %
Free operating cash flow/Total debt %
Return on capital %
Operating income/Sales
Long-term debt/Capital
Total debt/Capital

16. Financial distress
Financial distress can also be directly predicted.

17. Prediction of bankruptcy
Bankruptcy prediction models are used in the same way as the bond ratings prediction models.
Dependent variable is a dummy variable indicating whether or not the firm went bankrupt.
Beaver (1966) investigated the use of financial ratios in the bankruptcy prediction.
The results clearly indicate that values of the financial ratios differ between failed and non-failed firms.

18. Prediction of financial distress Univariate models
Beaver (1966) relied on
Cash flow to total debt
Net income to total assets
Total debt to total assets
Working capital to total assets
Current ratio

19. Example: Cash flow / total debt

20. Example (cont.): Net income / total assets

21. Example (cont.): Total debt / total assets

22. Example (cont.): Working capital / total assets

23. Example (cont.): Current ratio

24. Predicting Financial Distress
Altman Z-Score
X1 = Working capital/Total assets
X2 = Retained earnings/Total assets
X3 = Earnings before interest and taxes/Total assets
X4 = Shareholders’ market value/Total liabilities
X5 = Sales/Total assets
Z<1.81 implies a high probability of bankruptcy
Z>2.99 implies a low probability of bankruptcy
1.81<Z<2.99 implies an ambiguous area 2 2

25. Prediction of financial distress Multivariate models
Altman Z-score
(Current assets – current liabilities)/total assets
Retained earnings/Total assets
EBIT/Total assets
Preferred and common stock market value/Book value of liabilities
Sales/Total assets
Nokia = 9.88
Motorola = 1.71 (below the 2.99 nonbankrupt benchmark)

26. Motorola, Note 8 Off-balance-sheet financing
“At December 31, 2001, future minimum lease obligations, net of minimum sublease rentals, for the next five years and beyond are as follows: 2002—$150 million; 2003—$117 million; 2004—$97 million; 2005—$76 million; 2006—$63 million; beyond—$90 million.”
The present value of these payments, at 7%, is $484 million
Inclusion of these items increases debt by 5%

27. Nokia debt note detail Operating lease payments

28. Elements of Free Operating Cash Flow
2001
Nokia (EURm)
Motorola ($m)
EBITDA
5,735
(4,039)
Non-cash items
248
(2,273)
Fund from operations
5,983
(6,312)
Capital expenditures
(1,041)
(1,321)
Working capital change
978
1,527
Free operating cash flow
5,920
(6,106)

29. Debt Analysis Ratios

31. More Recent Advances in Distress Prediction
RiskCalc
Market (Merton) Model

33. RiskCalc™
“The model's key advantage derives from Moody's unique and proprietary middle market private firm financial statement and default database (Credit Research Database), which comprises 28,104 companies and 1,604 defaults. Our main insights and conclusions are: …
Comprehensive testing and validation suggest that RiskCalc's predictive power is superior to that of other publicly available benchmark models and is robust across non-financial industry sectors, and over time.
RiskCalc™ was developed to achieve maximum predictive power with the smallest number of inputs. It requires just 10 financial ratios & indicators computed from 17 basic financial inputs.
RiskCalc's predictive power derives, in part, from its meticulous transformation of input financial ratios….” Source: RiskCalc™ For Private Companies: Moody's Default Model , may 2000

35. Transforming raw ratios

37. From Raw Data to Ratios

38. Contribution of Factors

39. Market Model (Not required)
Banks can use the theory of option pricing to assess the credit risk of a corporate borrower
The probability of default is positively related to:
the volatility of the firm’s stock
the firm’s leverage
A model developed by KMV corporation is being widely used by banks for this purpose