Corporate Bonds Default Risk

9 Key excerpts on "Corporate Bonds Default Risk"

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  eBook - ePub

  Quantitative Financial Risk Management

  • Michael B. Miller(Author)
  • 2018(Publication Date)
  • Wiley

    (Publisher)

  8 CREDIT RISK

  Credit risk is the risk that one party in a financial transaction will fail to pay the other party in that transaction. Credit risk can arise in a number of different settings, from bonds and derivatives, to counterparty risk and settlement risk. Our quantitative analysis will focus on the default risk of bonds, but these same tools can be applied in many settings involving credit risk.

  DEFAULT RISK AND PRICING

  We begin with a brief review of bonds and basic fixed‐income pricing. We first consider pricing without default, before moving on to pricing when default is possible.

  Bond Pricing

  Bonds can be issued by corporations and governments. Bonds issued by corporations are referred to as corporate bonds or simply corporates. Bonds issued by local governments are typically referred to as municipal bonds. Bonds issued by national governments are referred to as government or sovereign bonds. When referring to the risk of sovereign bonds defaulting we often talk of sovereign credit risk.

  In each case, the bond issuer has promised to make future payments to the bondholders. If the issuer fails to make a payment, or makes only a partial payment, they are said to have defaulted. Some bonds are issued with covenants that restrict what the issuer can and cannot do. For example, a corporation might include a covenant stipulating that it will maintain a certain debt‐to‐equity ratio. If the issuer violates a covenant, it is also considered to be a default. While this type of technical default is of interest, in this chapter we will only consider the former type of default, where the issuer fails to make a payment in full.

  In practice bonds can be very complicated instruments. They can be callable by the issuer, they can be convertible into common or preferred stock, or even have payments linked to other financial variables. Plain‐vanilla bonds have only coupon and principal payments. The principal, also referred to as the face value or notional, is typically a round number—in the US, $100 and $1,000 are very popular—and is paid to the bondholder when the bond matures. Coupons are periodic payments that the bond issuer makes to the bondholders. They are typically a small percentage of the notional. Coupon payments can be fixed or floating. Floating rates are often tied to benchmark interest rates (e.g., LIBOR).

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  eBook - ePub

  Encyclopedia of Financial Models

  • Frank J. Fabozzi(Author)
  • 2012(Publication Date)
  • Wiley

    (Publisher)

  Credit risk is the risk that a borrower will be unable to make payment of interest or principal in a timely manner. Under this definition, a delay in repayments, restructuring of borrower repayments, and bankruptcy, which constitute default events, will fall under credit risk. In addition to this, the mark-to-market loss of a bond resulting from a change in the market perception of the issuer to service the debt in future is also attributed to credit risk. This manifests itself in the form of a widening of the credit spread of the security in question against a risk-free asset, such as the Treasury bond, of similar maturity. The fluctuations in the credit spread between the two securities reflect views on the intrinsic creditworthiness of the issuer of the defaultable security.

  The key determinants of credit risk at the security level include probability of default (PD) of the issuer, that is, the probability that the issuer will default on its contractual obligations to repay its debt; recovery rate given that the issuer has defaulted; and rating migration probabilities, that is, the extent to which the credit quality of the issuer improves or deteriorates as expressed by a change in the probability of default of the issuer. The following sections discuss in greater detail these determinants of credit risk for corporate issuers, and wherever relevant, methods commonly employed to estimate them will be indicated.

  Probability of Default

  Assessments about an issuer's ability to service debt obligations play a fundamental role in establishing the level of credit risk embedded in a security. This is usually expressed through the default probability that quantifies the likelihood of the issuer not being able to service the debt obligations. Since probability of default is a function of the time horizon over which one measures the debt servicing ability, it is standard practice to assume a one-year time horizon to quantify this.

  In general, the approaches used to determine default probabilities at the issuer level fall into two broad categories. The first is empirical in nature and requires the existence of a public credit-quality rating scheme. The second is based on Merton's options theory framework (Merton, 1974), and hence, is a structural approach. The empirical approach to estimating PD makes use of a historical database of corporate defaults to form a static pool of companies having a particular credit rating for a given year. Annual default rates are then calculated for each static pool, which are then aggregated to provide an estimate of the average historical default probability for a given credit rating. If one uses this approach, then the default probabilities for any two issuers having the same credit rating will be identical. The option pricing approach to estimate default probability makes use of the current estimates of the firm's assets, liabilities, and asset volatility, and hence, is related to the dynamics of the underlying structure of the firm. Each of these approaches is discussed below in greater detail.

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  eBook - PDF

  Fixed Income Analysis

  • (Author)
  • 2022(Publication Date)
  • Wiley

    (Publisher)

  A default can lead to losses of various mag- nitudes. In most instances, in the event of default, bondholders will recover some value, so there will not be a total loss on the investment. Thus, credit risk is reflected in the distribution of potential losses that may arise if the investor is not paid in full and on time. Although it is sometimes important to consider the entire distribution of potential losses and their respec- tive probabilities—for instance, when losses have a disproportionate impact on the various tranches of a securitized pool of loans—it is often convenient to summarize the risk with a single default probability and loss severity and focus on the expected loss: Expected loss = Default probability × Loss severity given default The loss severity, and hence the expected loss, can be expressed as either a monetary amount (e.g., €450,000) or as a percentage of the principal amount (e.g., 45%). The latter form of expression is generally more useful for analysis because it is independent of the amount Chapter 6 Fundamentals of Credit Analysis 259 of investment. Loss severity is often expressed as (1 − Recovery rate), where the recovery rate is the percentage of the principal amount recovered in the event of default. Because default risk (default probability) is quite low for most high-quality debt issuers, bond investors tend to focus primarily on assessing this probability and devote less effort to assessing the potential loss severity arising from default. However, as an issuer’s default risk rises, investors will focus more on what the recovery rate might be in the event of default. This issue will be discussed in more detail later. Important credit-related risks include the following: • Spread risk. Corporate bonds and other “credit-risky” debt instruments typically trade at a yield premium, or spread, to bonds that have been considered “default-risk free,” such as US Treasury bonds or German government bonds.

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  Managing Credit Risk in Corporate Bond Portfolios

  A Practitioner's Guide

  • Srichander Ramaswamy(Author)
  • 2004(Publication Date)
  • Wiley

    (Publisher)

  2. An issuer files for bankruptcy or legal receivership occurs. 3. A distressed exchange occurs where: (1) the issuer offers bondholders a new security or package of securities that amounts to a diminished financial obligation or (2) the exchange has the apparent purpose of helping the borrower default. These definitions of default are meant to capture events that change the relationship between the bondholder and the bond issuer in such a way as to subject the bondholder to an economic loss. The empirical approach relies on historical defaults of various rated issuers. This requires forming a static pool of issuers with a given rating every year and computing the ratio of defaulted issuers after a 1-year peri- od to the number of issuers that could have potentially defaulted for the given rating. If, during the year, ratings for certain issuers are withdrawn, then these issuers are subtracted from the potential number of issuers who could have defaulted in the static pool. Specifically, the 1-year default rates for A-rated issuers during a given year represent the number of A-rated issuers that defaulted over the year divided by the number of A-rated issuers that could have defaulted over that year. Annual default rates cal- culated in this manner for each rating grade are then aggregated to provide an estimate of the average historical default probability for a given rating grade. 70 MANAGING CREDIT RISK IN CORPORATE BOND PORTFOLIOS I mentioned that although different debt issues of a particular issuer could have different ratings assigned depending on the seniority of the issue, cross-default clauses require all outstanding debt of a particular issuer to default at the same time. This raises an important question when managing corporate bond portfolios, namely, whether the issuer rating or the rating of the bond issue is to be considered when inferring the probability of default.

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  eBook - ePub

  Introduction to Financial Mathematics

  With Computer Applications

  • Donald R. Chambers, Qin Lu(Authors)
  • 2021(Publication Date)
  • Chapman and Hall/CRC

    (Publisher)

  8  

  Credit Risk and Credit Derivatives

   

  This chapter first examines various default probabilities and how to extract default probabilities from market prices, and then it introduces single-name credit derivatives, in particular, credit default swaps (CDSs). Valuation of credit derivatives is discussed both from the analytical perspective and from the simulation perspective. This chapter also discusses multiple-name credit derivatives, primarily collateralized debt obligations (CDOs). First, CDOs are discussed with the assumption of uncorrelated bond defaults. Then, the effects of correlation and the simulation of the prices of CDOs with positively correlated bond defaults are considered. Finally, CDO squareds are briefly discussed. The chapter concludes with a discussion of credit derivatives and the 2007–2008 global financial crisis.

   

  8.1 Default Probabilities and Extract Default Probabilities from Market

  Default risk is the chance that companies or individuals will fail to make the required payments on their debt obligations. Credit risk is often interpreted as being synonymous with default risk, but can also be used to include broader issues such as the potential economic effects of changes in credit spreads or credit ratings. A credit rating is an evaluation of the credit risk of a prospective debtor, which is an implicit forecast of the likelihood of the debtor defaulting. Credit ratings are important metrics within the financial industry. Rating agencies analyze the credit risk of most publicly traded credit-based securities. Rating agencies are for-profit firms that in recent decades have been primarily paid by firms to rate their new securities rather than being paid by investors subscribing to their publications (as was common decades ago). In the United States, the SEC(Securities and Exchange Commission) recognizes several NRSROs (Nationally Recognized Statistical Rating Organizations)

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  eBook - ePub

  Managing Credit Risk

  The Great Challenge for Global Financial Markets

  • John B. Caouette, Paul Narayanan, Robert Nimmo, Edward I. Altman(Authors)
  • 2011(Publication Date)
  • Wiley

    (Publisher)

  We present and discuss each of these statistical methodologies and results carefully as it is very important for the user to understand the subtleties, as well as the magnitudes, of these risk measures when applying them to their own portfolios as well as when determining risk-capital requirements under Basel II. In addition, the PD of a corporate counterparty is fundamental to the pricing and evaluation of a credit default swap (CDS) or a CDO on a bundle of CDSs. In this chapter, we focus on corporate bonds and corporate loans in the United States, with some reference to other areas and asset classes, for example, structured products such as asset-backed securities (ABS). In particular, we concentrate on corporate high-yield (or junk bonds) and their loan counterpart, leveraged loans. The reason is that these asset classes are almost always the risk class designation of a corporate credit asset just prior to a default. HIGH-YIELD BOND DEFAULT RATES As noted thus far, a relevant metric for assessing default risk in the corporate sector is the high-yield, or junk bond, market default rate over various periods of time. This market has grown from a nearly all fallen-angel market—that is, investment grade that does not age well and gets downgraded to noninvestment grade or junk status—in 1998 of about $7 billion to about $1 trillion in 2006 (see Figure 15.1). In a sense, these high-yield, high-risk bonds are the raw material for possible defaults. FIGURE 15.1 Size of the U.S. High-Yield Bond Market 1978–2006 Note: Defaults are defined as bond issues that have missed a payment of interest and this delinquency is not cured within the grace-period (usually 30 days), or the firm has filed for bankruptcy under reorganization (Chapter 11) or liquidation (Chapter 7), or there is an announcement of a distressed-restructuring

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  eBook - ePub

  2022 CFA Program Curriculum Level II Box Set

  • (Author)
  • 2021(Publication Date)
  • Wiley

    (Publisher)

  We assume that the corporate bond and the default-risk-free government bond have the same taxation and liquidity. This is a simplifying assumption, of course. In reality, government bonds typically are more liquid than corporate bonds. Also, differences in liquidity within the universe of corporate bonds are great. Government bonds are available in greater supply than even the most liquid corporates and have demand from a wider set of institutional investors. In addition, government bonds can be used more readily as collateral in repo transactions and for centrally cleared derivatives. Also, there are differences in taxation in some markets. For example, interest income on US corporate bonds is taxable by both the federal and state governments. Government debt, however, is exempt from taxes at the state level. Disregarding tax and liquidity differences allows us to focus on default risk and expected loss as the determining factors for the credit spread.

  The first factor to consider in modeling credit risk is the expected exposure to default loss. This quantity is the projected amount of money the investor could lose if an event of default occurs, before factoring in possible recovery. Although the most common event of default is nonpayment leading to bankruptcy proceedings, the bond prospectus might identify other events of default, such as the failure to meet a different obligation or the violation of a financial covenant.

  Consider a one-year, 4% annual payment corporate bond priced at par value. The expected exposure to default loss at the end of the year is simply 104 (per 100 of par value). Later, we will include multiple time periods and volatility in interest rates. That complicates the calculation of expected exposure because we will need to consider the likelihood that the bond price varies as interest rates vary. In this initial example, the exposure is simply the final coupon payment plus the redemption of principal.

  The second factor is the assumed recovery rate , which is the percentage of the loss recovered from a bond in default. The recovery rate varies by industry, the degree of seniority in the capital structure, the amount of leverage in the capital structure in total, and whether a particular security is secured or otherwise collateralized. We assume a 40% recovery rate for this corporate bond, which is a common baseline assumption in practice. Given the recovery rate assumption, we can determine the assumed loss given default (the amount of loss if a default occurs). This is 62.4 per 100 of par value: 104 × (1 – 0.40) = 62.4. A related term is loss severity

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  eBook - PDF

  Debt Markets and Analysis

  • R. Stafford Johnson(Author)
  • 2013(Publication Date)
  • Bloomberg Press

    (Publisher)

  The most current conditional probabilities can be found on the Bloomberg RATD screen. Bloomberg estimates of conditional probabilities as of January 16, 2012, are shown in Exhibit 5.6. Default and Recovery Rates Holders of defaulted bonds usually recover a percentage of their investment—the recovery rate. As a result, the default loss rate from an investment is lower than the default rate: Default Loss Rate Default Rate ( Recovery Rate) = - 1 Bond Risk 185 For example, if the recovery rate from a defaulted bond is estimated to be 30 percent and the bond’s default rate is 6 percent, then the default loss rate would be 4.2 percent: Default Loss Rate 6 percent ( ) 4.2 percent = - = 1 30 . Focusing on just the default rate highlights the worst possible scenario. Moody’s, Fitch, and Standard & Poor’s have developed recovery rating scale systems for secured corporate bonds. These ratings scale system estimate historical recovery rates based on collateral, subordination, debt in the capital structure, and expected value of the issue in distress. The recovery rating scale systems of Standard & Poor’s and Fitch are shown in Exhibit 5.7. Downgrades and Upgrades Credit risk includes not only the concern over default but also the chance of a bond’s rating being downgraded. The downgrade of a bond or the market expectation of a downgrade leads to an increase sale of the bond by its holders and a lower demand by investors, both of which lower the bond’s price and increases its credit spread. Exhibit 5.8 shows the recent history of ratings changes for Ford and Kraft. EXHIBIT 5.6 Bloomberg Conditional Probabilities

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  eBook - PDF

  The Trustee Guide to Investment

  • A. Clare, C. Wagstaff(Authors)
  • 2011(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  For instance, historically less than one in a thousand triple-A rated bonds default within ten years of being issued, whereas about 80 per cent of triple-C bonds default within the first ten years. • • • Exhibit 6.6 Key financial ratios by credit rating AAA AA A BBB BB B CCC Pre-tax interest coverage, times 17.6 7.6 4.1 2.5 1.5 0.9 0.7 Free operating cash flow/Total debt, % 42.3 28 13.6 6.1 3.2 1.6 0.8 Total debt/Total capital, % 21.9 32.7 40.3 48.8 66.2 71.5 71.2 100 The Trustee Guide to Investment However, a default is not always as bad as it sounds. Although a default usually occurs when an issuer fails to meet their contractual interest and/or redemp- tion payment obligations, it can also be triggered if the issuer breaches one of a number of financial ratios set out in the bond indenture. Neither should a default always result in the investor losing all of their money. Indeed, on many occasions, the default is often remedied by the issuer shortly after it occurs and even when it is not, the ‘recovery rate’ on most defaults average about 40 per cent of what’s owed. The reason for this is that bond holders usually rank above most of the company’s other stakeholders, including the company’s DB pension scheme as an unsecured creditor. Credit spreads Although credit ratings act as a guide to the likelihood of default, one criticism of credit ratings is that they are backward looking and are not adjusted in real time. By contrast, credit spreads are forward looking and reflect investors’ assessment of creditworthiness in real time. The credit spread is the additional yield on a corporate bond, or corporate bond index, over and above the yield on an equivalent maturity government bond. While the credit spread also embodies compensation for liquidity risk and risk associated with the price volatility of the bond, it is, in the main, a reflection of the amount of credit risk inherent in the bond, which is set by the interaction of buyers and sellers in the bond market.

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