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Credit Risk

Credit Risk. Bond rating agencies Moody’s Investor Service Standard & Poor’s Bought Canadian Bond Rating Services (CBRS) Fitch Dominion Bond Rating Services (DBRS) Canadian Bond rating categories Investment grade (BBB and above) Speculative grade (BB and below) ~ Junk bonds

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Credit Risk

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  1. Credit Risk • Bond rating agencies • Moody’s Investor Service • Standard & Poor’s • Bought Canadian Bond Rating Services (CBRS) • Fitch • Dominion Bond Rating Services (DBRS) • Canadian • Bond rating categories • Investment grade (BBB and above) • Speculative grade (BB and below) ~ Junk bonds (Fallen angels: once investment grade, now junk)

  2. Bond Rating Process: New Issuer • Initiation (by the issuer or its investment banker) • Letter of engagement • Gathering of information • Meeting with management • Draft report • Rating committee • Review by the issuer (factual accuracy/confidential info) • Publishing • Monitoring

  3. Financial Ratios by Rating Class

  4. Reuters yield spreads for Industrials (US) Source: Bondsonline Spread values represent basis points (bps) over a US Treasury security of the same maturity, or the closest matching maturity

  5. Predicting default: Altman’s Z-score • A type of discriminant analysis • Collect financial data for a sample of bankrupt firms one year prior to default • Collect financial data for a sample of similar, but solvent firms • Find a function of financial ratios (profitability, leverage, liquidity) that separates the bankrupt from the solvent firms • Use this function to predict default

  6. Z-score: Graph • 0.75 = 0.9 ROE + 0.4 Coverage ratio • (0.75, 0.9, and 0.4 are estimates from the statistical analysis. 0.75 is called the critical level)

  7. Altman’s Estimates for Canadian Companies • Predicting equation: Firms with Z > 1.626 were “safe”, and firms with Z < 1.626 were in risk of default For U.S companies, there are online calculators

  8. Protection Against Default Can specify in the bond indenture: • Sinking fund provisions • Periodic payments made by bond issuer to reduce the amount of outstanding principal at maturity (via a trustee) • Subordination of future debt • Dividend restrictions • Collateral • Property  mortgage bond • Other securities held by the firm  collateral trust bond • Equipment  equipment obligation bond

  9. Credit Risk and Yield • Credit (default) risk premium • Also called the “yield spread” • Difference in YTM between a risky bond and a “safe” bond of the same term to maturity • Should expect: low bond rating  high YTM • Yield spreads vary over the business cycles: flight to quality during recessions

  10. TED Spread • Spread: 3-month LIBOR minus 3-month T-bill • Default risk of interbank loans • October 10, 2008 (465 bp) Source: Bloomberg

  11. Overnight interest rates • Federal funds rate • Interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight • Banks’ borrowing cost in the overnight lending market • In 1995, the Feds began to explicitly state its target level for the federal funds rate • Serves as the price target of monetary policy • Overnight rate • Canadian equivalent

  12. More Definitions • Discount rate • Overnight interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility

  13. How the LIBOR is set Source: New York Times

  14. What depends on the LIBOR?

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