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There are some investments, however, in which the cash flows are promised when the investment is madeModels of Default Risk The risk that we have discussed hitherto in this chapter relates to cash flows on investments being different from expected cash flows. There are some investments, however, in which the cash flows are promised when the investment is made. This is the case, for instance, when you lend to a business or buy a corporate bond; the borrower may default on interest and principal payments on the borrowing. Generally speaking, borrowers with higher default risk should pay higher interest rates on their borrowing than those with lower default risk. This section examines the measurement of default risk and the relationship of default risk to interest rates on borrowing. In contrast to the general risk and return models for equity, which evaluate the effects of market risk on expected returns, models of default risk measure the consequences of firm-specific default risk on promised returns. While diversification can be used to explain why firm-specific risk will not be priced into expected returns for equities, the same rationale cannot be applied to securities that have limited upside potential and much greater downside potential from firm-specific events. To see what we mean by limited upside potential, consider investing in the bond issued by a company. The coupons are fixed at the time of the issue and these coupons represent the promised cash flow on the bond. The best case scenario for you as an investor is that you receive the promised cash flows; you are not entitled to more than these cash flows even if the company is wildly successful. All other scenarios contain only bad news, though in varying degrees, with the delivered cash flows being less than the promised cash flows. Consequently, the expected return on a corporate bond is likely to reflect the firmspecific default risk of the firm issuing the bond. The Determinants of Default Risk The default risk of a firm is a function of two variables. The first is the firms capacity to generate cash flows from operations and the second is its financial obligations - including interest and principal payments7. Firms that generate high cash flows relative to their financial obligations should have lower default risk than firms that generate low cash flows relative to their financial obligations. Thus, firms with significant existing investments, which generate relatively high cash flows, will have lower default risk than firms that do not. In addition to the magnitude of a firms cash flows, the default risk is also affected by the volatility in these cash flows. The more stability there is in cash flows the lower the default risk in the firm. Firms that operate in predictable and stable businesses will have lower default risk than will other similar firms that operate in cyclical or volatile businesses. Most models of default risk use financial ratios to measure the cash flow coverage (i.e., the magnitude of cash flows relative to obligations) and control for industry effects to evaluate the variability in cash flows. Bond Ratings and Interest rates The most widely used measure of a firms default risk is its bond rating, which is generally assigned by an independent ratings agency. The two best known are Standard and Poors and Moodys. Thousands of companies are rated by these two agencies and their views carry significant weight with financial markets. The Ratings Process The process of rating a bond usually starts when the issuing company requests a rating from a bond ratings agency. The ratings agency then collects information from both publicly available sources, such as financial statements, and the company itself and makes a decision on the rating. If the company disagrees with the rating, it is given the opportunity to present additional information. This process is presented schematically for one ratings agency, Standard and Poors (S&P), in Figure 4.7. THE RATINGS PROCESS Issuer or authorized representative request rating Presentation of the analysis to the S&P rating commitee Discussion and vote to determine rating Requestor completes S&P rating request form and issue is entered into S&Ps administrative and control systems. Notification of rating decision to issuer or its authorized representative S&P assigns analytical team to issue Final Analytical review and preparation of rating committee presentation Does issuer wish to appeal by furnishing additional information? Yes Analysts research S&P library, internal files and data bases Issuer meeting: presentation to S&P personnel or S&P personnel tour issuer facilities Format notification to issuer or its authorized representative: Rating is released Presentation of additional information to S&P rating committee: Discussion and vote to confirm or modify rating. The ratings assigned by these agencies are letter ratings. A rating of AAA from Standard and Poors and Aaa from Moodys represents the highest rating granted to firms that are viewed as having the lowest default risk. As the default risk increases, the ratings decrease toward D for firms in default (Standard and Poors). A rating at or above BBB by Standard and Poors is categorized as investment grade, reflecting the view of the ratings agency that there is relatively little default risk in investing in bonds issued by these firms. Determinants of Bond Ratings The bond ratings assigned by ratings agencies are primarily based upon publicly available information, though private information conveyed by the firm to the rating agency does play a role. The rating assigned to a companys bonds will depend in large part on financial ratios that measure the capacity of the company to meet debt payments and generate stable and predictable cash flows. While a multitude of financial ratios exist, table 4.6 summarizes some of the key ratios used to measure default risk. Note that the pre-tax interest coverage ratio (EBIT) and the EBITDA interest coverage ratio are stated in terms of times interest earned, whereas the rest of the ratios are stated in percentage terms. Not surprisingly, firms that generate income and cash flows significantly higher than debt payments, that are profitable and that have low debt ratios are more likely to be highly rated than are firms that do not have these characteristics. There will be individual firms whose ratings are not consistent with their financial ratios, however, because the ratings agency does add subjective judgments into the final mix. Thus, a firm which performs poorly on financial ratios but is expected to improve its performance dramatically over the next period may receive a higher rating than is justified by its current financials. For most firms, however, the financial ratios should provide a reasonable basis for guessing at the bond rating. ratingfins.xls: There is a dataset on the web that summarizes key financial ratios by bond rating class for the United States in the most recent period for which the data is available. Bond Ratings and Interest Rates The interest rate on a corporate bond should be a function of its default risk, which is measured by its rating. If the rating is a good measure of the default risk, higher rated bonds should be priced to yield lower interest rates than would lower rated bonds. In fact, in chapter 5, we will define the difference between the interest rate on a bond with default risk and a default-free government bond to be the default spread. This default spread will vary by maturity of the bond and can also change from period to period, depending on economic conditions. In chapter 7, we will consider how best to estimate these default spreads and how they might vary over time. |
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