Credit Risk Analysis

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Credit Risk Analysis
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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

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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

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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 issuers
  financial strength and the terms of the bond
  contract.

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Default Risk

• A bond also has legal rights attached to it
• if the borrower doesnt make the required
  payments, bondholders can force bankruptcy
  proceedings
• in the event of bankruptcy, bond holders get paid
  before equity holders

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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.

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Credit rating

• Rely on qualitative and quantitative analyses
• Standard Poors (AAA to D)
• Intermediate /- scores
• Moodys (Aaa to C)
• Intermediate 1,2,3 scores
• Fitch (AAA to D)

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Rating Criteria

• Bond Quality Ratings
• Rating Grades Standard Poors Moodys
• 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

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Now more competition!

• Of the more than 130 credit-rating agencies, the
  SEC has granted only five the designation NRSROs
  Moody's, SP, 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)."

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Rating Debt Obligations
Ratings and Yields
Source Standard Poors, 2002
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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

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Standard Poors rating method

1. EBIT interest coverage
2. EBITDA interest coverage
3. Funds from operations/Total debt
4. Free operating cash flow/Total debt
5. Return on capital
6. Operating income/Sales
7. Long-term debt/Capital
8. Total debt/Capital

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Financial distress

• Financial distress can also be directly predicted.

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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.

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Prediction of financial distressUnivariate 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

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Example Cash flow / total debt

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Example (cont.) Net income / total assets

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Example (cont.) Total debt / total assets

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Example (cont.) Working capital / total assets

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Example (cont.) Current ratio

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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 Zlt1.81 implies a high
probability of bankruptcy Zgt2.99 implies a low
probability of bankruptcy 1.81ltZlt2.99 implies an
ambiguous area
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Prediction of financial distressMultivariate
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)

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Motorola Liabilities
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Motorola, Note 3
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Motorola, Note 3
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Motorola, Note 8Off-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
  2002150 million 2003117 million
  200497 million 200576 million
  200663 million beyond90 million.
• The present value of these payments, at 7, is
  484 million
• Inclusion of these items increases debt by 5

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Nokia Liabilities
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Nokia debt note detail
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Nokia debt note detailOperating lease payments
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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)
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Debt Analysis Ratios
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Additional considerations

• Mezzanine items
• Could be debt or equity
• Off-balance-sheet liabilities
• Operating leases
• Contingent liabilities
• Environmental liabilities

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More Recent Advances in Distress Prediction

• RiskCalc
• Market (Merton) Model

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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
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Transforming raw ratios
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From Raw Data to Ratios
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Contribution of Factors
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The parameters
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For more details on RiskCalc

• http//riskcalc.moodysrms.com/us/research/crm/5640
  2.pdf

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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 firms stock
• the firms leverage
• A model developed by KMV corporation is being
  widely used by banks for this purpose

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