CORPORATE FINANCE

23. Credit Risk and the Value

of Corporate Debt
Non-bank lenders will bear brunt of credit crisis
Financial risk has been pushed from banks into the shadows

Fed chair Jay Powell. The central bank was right to launch unlimited bond purchases and a facility to lend
directly to companies
Regulators scrambled to strengthen the banking system after the 2008 financial crisis. That made banks safer
but their actions pushed the risk of rising defaults into the shadows. While the banks — designated as
systemically important — repaired and tidied up their balance sheets, asset managers, hedge funds and others
stepped into the gap, providing credit to the non-financial economy. Investor money flowed in, searching for
yield.
Now those shadow banks — lenders that are not regulated like banks — are causing worries about systemic
risk as the impact of coronavirus spreads. An index tracking US Business Development Companies, listed
lenders to small businesses, has halved since February.
Financial Times MARCH 24 2020
Corporate Finance II José A. de Azevedo Pereira 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

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 Defaulting Debt Levels

Face value of defaulting debt

350

300

250
$ billions

200

150

100

50

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 Valuing Risky Bonds

The risk of default changes the price of a bond and the

YTM.

Example
We have a 5% one-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?

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 Valuing Risky Bonds
Example
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
1,050 .80 = 840.00
500 .20 = 100.00 .
940.00 = expected CF
940
Value = = $895
1.05
1050
YTM = − 1 = 17 .3%
895
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 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:

940
Value = = $ 870 .00
1 .08
1050
YTM = − 1 = 20 .7 %
870 .00

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 Yield, %

0
2
4
6
8
10
12
14
16
18
1980
1981

Corporate Finance II
1982
1983
1984
1985
Baa
Aaa

1986
1987
High yield

1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999

José A. de Azevedo Pereira

Yield Spreads

2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
8
 Credit Default Swap Data

600

Pfizer
500
Dow Chemical
Bank of America
400
Basis points

300

200

100

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 The Option to Default
Example
Circular File borrowed $50, but then the firm fell on hard times
and the market value of its assets fell to $30. Circular’s bond
and stock prices fell to $25 and $5, respectively. Thus
Circular’s market-value balance sheet is:

Circular File Company (market values)

Asset value $30 $25 Bonds

$ 5 Stock
$30 $30 Firm value

Circular File Company (market values)

Asset value $30 $25 Bonds = asset value – call value

$ 5 Stock = value of a call
$30 $30 Firm value = asset value
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 The Option to Default

Example (continued) - The value of Circular’s common

stock is the value of a call option on the firm’s assets with
an exercise price of $50.

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 Interest Rates, Risk, and Maturity

How the betas of the debt and equity vary with the degree of
leverage and the maturity of the debt

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 Key to Bond Ratings
Moody's S&P's & Fitch
Investment Grade
Aaa AAA The highest quality
Aa AA bonds are rated triple-
A A A. Investment grade
Baa BBB
Junk Bonds
bonds have to be
Ba BB equivalent of Baa or
B B higher. Bonds that
Caa CCC don’t make this cut
Ca CC
C C are called “high-yield”
or “junk” bonds.

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 Bond Ratings and Financial Ratios
How financial ratios differ according to a firm’s bond
rating. Median ratios for U.S. nonfinancial firms by
bond rating.

Source: Moody’s Financial Metrics: Key Ratios by Rating and Industry for North American Non-Financial
Corporations, December 2013.
 Bond Ratings and Default
Default rates of corporate bonds 1970-2012 by
Moody’s rating at time of issue

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 Predicting Default

A comparison of financial
statements from firms
that have gone bankrupt
with those firms that
have not gone bankrupt
reveals information
valuable to the lending
decision.

Financial ratios of 544 failing and non-failing firms

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 Predicting Default

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 Predicting Default

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 Predicting Default

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 Credit Analysis

Predicting Default - William Beaver, Maureen McNichols, and

Jung-Wu Rhie, studied defaulting and non-defaulting firms and
concluded the chance of failing during the next year relative to
the chance of not failing was best estimated by the following
equation:

Log (relative chance of failure)

= −6.445 − 1.192 ROA + 2.307 liabilities/assets − .346 EBITDA/liabilities

Relative chance of failure = e L

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 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

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 Asset Value and Default
The market value of J.C. Penney’s assets, as
default approached

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 Default Probability
Moody’s estimate of J.C. Penney’s
probability of default

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 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

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 Value at Risk (VaR)

Standard Measurements
 10 days

σ 10 = σ day × 10
 99% confidence interval

99 % = σ × 2 . 33
 VaR

VaR = (σ 10 × 2.33) × (asset value )

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 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.

σ 10 = .02 × 10
= 6.32%

99%(σ ) = .0632 × 2.33

= 14.74%
VaR = .1473 ×10,000,000
= $1,473,621
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 Value at Risk (VaR)

Example
 You also own $5 mil of AT&T, with a daily volatility of 1%. AT&T and IBM have a
.7 correlation coefficient.
 What is the VaR of AT&T and the combined portfolio?

VaR IBM = $1,473,621

VaR AT&T = $368,405 Diversification Benefit
= $90,647
VaR AT&T + IBM = $1,842,026

VaR Portfolio = $1,751,379

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 Ratings Changes

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 Thank You

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