Presentation Transcript

1. Credit Risk and Corporate Debt Securities Topic 8
2. Credit Risk The possibility of default, a risk-adjusted present value. Rating agencies attempt to quantify the risk.
3. Macroeconomic Events and Defaults by Companies In 1990, following the banking crisis in the United States, dollar volume of defaults by all rated companies ballooned to $22,093 million. Nearly a decade later, in the period 1999 – 2002, the volume of default again ballooned following the bursting of the dot-com bubble, reaching levels ranging from $41,812 million in 1999 to $212,029 million in 2002.
4. Macroeconomic Events and Defaults by Companies Speculative-grade companies accounted for all the defaults in 1990. In Sharp contrast, in 1999, over 60% of the volume of defaults came from investment-grade companies. In fact, a review of data during 1999 – 2002 shows that investment-grade companies have contributed as much as the speculative-grade companies to the volume of defaults. Most had clean audits the previous fiscal year, some even a few months prior to their defaults and eventual bankruptcies. Credit events
5. Macroeconomic Events and Defaults by Companies Spikes in default rates during the 1930s and early 1970s, accompanied by widening spreads, suggest a strong relationship between economic slowdown and corporate financial health. Recession may lead to slowdowns and correlated defaults by many firms within the same industry. One can therefore expect the default rates to go up and the recovery rates for lenders to go down; as more companies within the same industry are more likely to default in recession, the resale values of assets may be much lower in recession. In contrast, the value of assets of a company that defaults when other companies in the same industry are doing better could be much higher. Trading strategy?
6. Effect of Business Cycles on recovery rates
7. Rating Categories – Investment and Junk categories
8. Rating Migration Probabilities
9. Bond holders are short an option When the firm is healthy, bondholders get the value of their bonds, otherwise the value of the firm less bankruptcy costs.
10. Bond holders are short an option Corporate debt investors are essentially short a put option: When the value of the firm is low, equity holders can put the firm to bond investors and walk away from their contractual debt obligations. This approach implies the following important relationship: Risky loan = Risk-free loan - Put value to default Or Put = Risk-free loan – Risky loan
11. Bond holders are short an option Equity is a call option on the assets of the firm with a strike price equal to the face value of debt. It can be written as: Max [0, Vt – F]
12. Value of Debt Fe-r(T-t)N(d2) + VtN(-d1) Where: d2 = - The first part is the value of a zero, the second is the value of the put option on the asses, with strike equal to the face of debt.
13. Credit Spreads Increase in Leverage
14. Credit Spreads Increase in Business Risk
15. Credit Spreads and Rating Categories
16. Implementing Merton’s Model
17. KMV Model to derive expected default frequencies Equity is a call option on the assets of the firm with a strike price equal to the face value of debt.
18. Implementing Merton’s Model
19. Expected Default Frequency (EDF) Implementing Merton’s Model
20. Expected Default Frequency (EDF)
21. Session - Conclusions/Main insights Defaults and recovery rates are related to business cycles and company-specific factors. Rating agencies broadly classify debt into investment grade and junk grade. Within each of these, there are many sub-categories. Credit spreads are related to rating but there are variations of spreads within each category of rating. Structural models of default such as the one by Merton recognize that bond holders are short an option. Hence they demand compensation over the risk-free rate by the value of the option.
22. Session - Conclusions/Main insights Credit spreads tend to increase in a) leverage, and b) business risk. Expected Default Frequencies (EDF) can be derived from Equity prices based on Merton’s model. EDFs are used in practice to monitor the credit risk of loan and bond portfolios, and serve as a market-derived signal to supplement ratings.