Chap 11 A
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BONDS AND BOND VALUATION QUESTIONS: What’s the ? Need this to determine the value of the equity! What’s the ? Need this and the for the WACC WACC re ( L )
E D rd 1 tc ED ED
Note that rd is the expected cost of debt = the expected return promised return
Chapter 11 slides, page 1
Of course we could calculate the WACC in some other way. For example, when T = 0: r (U ) WACC
Chapter 11 slides, page 2
D 1 t c E D 1 E
re ( L) rf debt
SOME PRELIMINARIES
Can be computed from return data (see Chapter 11 of book for example for Boeing) There is no commercial source for bond betas (as far as we know?—see Arthur Warga’s web site and see article in Financial Management, Spring 1996) Can be imputed from the SML for debt, if we know the expected return
Chapter 11 slides, page 3
IMPUTING A BOND BETA Debt SML (reminder): E rd rf debt d E rm rf debt1 tc where E rd expected return on debt security rf debt return on riskless debt E rm return on equity market portfolio tc marginal corporate tax rate Covr~m, r~d debt beta wrt equity market portfolio d Var r~ m
If we know expected return on debt we can calculate the debt A 3 market risk premium 4 risk-free rate 5 corporate tax rate, tc 6 slope of SML 7 8 expected bond return 9 10 implied beta
Chapter 11 slides, page 4
B C D E F 8.40% <-- Brealey and Myers 6.69% <-- AAA bond rate, 10 year corporates 36% 10.81% <-- market risk premium + tc*risk-free 8.00% 0.1212 <-- (B8-B4)/B6
BETAS FOR SELECTED VANGUARD FUNDS Note: The source is Vanguard's Web site--http://majestic1.vanguard.com This is not meant to be a scientific study!
Year Ended December 31 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 1977 beta wrt SP
Chapter 11 slides, page 5
Vanguard Index 500 Portfolio 22.9% 37.4% 1.2% 9.9% 7.4% 30.2% -3.3% 31.4% 16.2% 4.7% 18.1% 31.2% 6.2% 21.3% 21.0% -5.2% 31.9% 18.0% 5.9% -7.8%
Lehman Bond Index Portfolio
Municipal Bond High Long-Term LimitedYield U.S. Short-Term High-Yield Term Corporate Treasury Federal Municipals
VBIF 3.6% 18.2% -2.7% 9.7% 7.1% 15.2% 8.6% 13.6% 7.4% 1.1%
VMBF 4.1% 8.6% 0.1% 6.3% 6.4% 9.5% 7.0% 8.1% 6.4%
VFISF 9.5% 19.2% -1.7% 18.2% 14.2% 29.0% -5.8% 1.9% 13.6% 2.7% 16.9% 22.0% 7.9% 15.1% 27.5% 9.4% 3.4% 5.5%
VUSTX -1.3% 30.1% -7.0% 16.8% 7.4% 17.4% 5.8% 17.9% 9.2% -2.9%
VSGBX 4.8% 12.3% -0.9% 7.0% 6.2% 12.2% 9.3% 11.3% 5.7%
VWAHX 4.50% 18.10% -5.10% 12.70% 9.90% 14.70% 5.90% 11.10% 13.80% -1.60% 19.70% 21.70% 9.70% 10.40% 35.90% -8.80% -11.40% -1.20%
0.3374
0.1129
0.3587
0.5843
0.1908
0.3572
GNMA VFIIIX 5.2% 17.0% -1.0% 5.9% 6.8% 16.8% 10.3% 14.8% 8.8% 2.1% 11.7% 20.7% 14.0% 9.7% 31.6% 4.8%
0.3590
Lehman 3-year Municipal Bond Index 4.4% 8.9% 0.7% 6.2% 6.4% 10.3% 7.2% 7.7% 4.6%
0.1137
VANGUARD HIGH-YIELD MUNICIPALS 40%
y = 0.3572x + 0.0293 R2 = 0.156
Municipals
30% 20% 10% 0% -10%-10% 0% -20%
Chapter 11 slides, page 6
10%
20%
SP 500 Fund
30%
40%
CALCULATING THE EXPECTED RETURN OF A BOND—A SIMPLE EXAMPLE F = face value of the bond P = price of bond C = annual coupon rate of the bond = probability that the bond will not default at end of year = fraction of bond’s value bondholders collect upon default The expected end-of-year cash flow is: E CF 1 C F 1 F The expected return from the bond (i.e., the cost of debt): E rd
E CF 1 C F 1 F 1 1 P P
Chapter 11 slides, page 7
SIMPLE SPREADSHEET EXAMPLE
1 2 3 4 5 6 7 8 9 10 11
A B C D EXPECTED RETURN ON A ONE-YEAR BOND with an adjustment for default probability Assumes that face value equals 1 coupon rate market price
Expected CF Expected return
Chapter 11 slides, page 8
E
16% 0.98 90% <-- Non-default probability 80% <-- Recovery percentage 112.400% <-- =B7*(1+B5)+(1-B7)*B8 14.694% <-- =(B7*(1+B5-B8)+B8)/B6-1
CALCULATING RISK ADJUSTED EXPECTED BOND RETURNS A MORE GENERAL MODEL Start with a 3 period bond which has the following characteristics: C is the bond coupon rate P is the bond price F is the bond’s face value n is the probability of non-default in period n, conditional on non-default in periods 1, …, n-1. n is the recovery ratio in period n
Chapter 11 slides, page 9
The associated payoffs are given by the following tree: C+F C
C
-P
Chapter 11 slides, page 10
0
0
0
The probabilities on the payoff tree look like:
1
At every node the upper branch is the non-default probability. Multiplying these two trees node by node gives the expected bond payoffs. Taking the IRR gives the expected return on the bond. Formal model comes later.
Chapter 11 slides, page 11
Note that it’s possible that the expected return on the yield curves below are all equal to the AAA rate (this could happen with risk neutrality):
Chapter 11 slides, page 12
Long-Term Senior Debt Rating Symbols Investment-Grade Ratings
Speculative-Grade Ratings
S&P and others
Moody’s
Interpretation
S&P and others
Moody’s
Interpretation
AAA
Aaa
Highest Quality
BB+ BB BB-
Ba1 Ba2 Ba3
Likely to fulfill obligations; ongoing uncertainty
AA+ AA AA-
Aa1 Aa2 AA3
High Quality
B+ B B-
B1 B2 B3
High-risk obligations
A+ A A-
A1 A2 A3
Strong Payment Capacity
CCC+ CCC CCC-
Caa
Current vulnerability to default or in default (Moody’s)
BBB+ BBB BBB-
Baa1 Baa2 Baa3
Adequate Payment Capacity
C D
Ca D
In bankruptcy or default, or other marked shortcomings
Chapter 11 slides, page 13
Spreads between Corporate Bonds and U.S. Treasuries 1973-1987 Averages Rating Basis Points AAA 43 AA 73 A 99 BBB 166 BB 299 B 404 CCC 724 Note: Based on equally weighted averages of monthly spreads per rating category. Spreads for BB and B represent data for 1979-1987 only; spreads for CCC, data for 1982-1987 only. Source: Altman, Journal of Finance, 1989 Chapter 11 slides, page 14
Chapter 11 slides, page 15
RATING CLASSIFICATION OF NEW ISSUERS 1981 No. AAA AA A BBB BB B CCC Investment Grade Speculative Grade
5 9 20 9 14 19 1 43 34
1982 % 6.49 11.69 25.97 11.69 18.18 24.68 1.3 55.84 44.16
No. 14 14 30 15 16 17 1 73 34
1985 No. AAA AA A BBB BB B CCC Investment Grade Speculative Grade
7.1 17.05 23.01 13.92 16.48 21.59 0.85 61.08 38.92
No. 24 17 45 31 54 136 15 117 205
1989 No. AAA AA A BBB BB B CCC Investment Grade Speculative Grade
5 38 39 20 36 60 3 102 99
AAA AA A BBB BB B CCC Investment Grade Speculative Grade
Chapter 11 slides, page 16
7 36 104 106 125 155 4 253 284
13 28 36 30 26 35 6 107 67
No.
%
No.
13 34 44 18 17 10 8 109 35
% 7.45 5.28 13.98 9.63 16.77 42.24 4.66 36.34 63.66
No.
% 9.03 23.61 30.56 12.5 11.81 6.94 5.56 75.69 24.31
No.
% 2.16 8.43 32.75 16.67 16.67 22.35 0.98 60 40
No.
18 32 40 35 63 112 10 125 185
11 43 167 85 85 114 5 306 204
No.
11 44 68 27 27 8 9 150 44
2.9 12.32 19.57 12.32 22.46 28.26 2.17 47.1 52.9
1988 % 5.81 10.32 12.9 11.29 20.32 36.13 3.23 40.32 59.68
No.
% 5.67 22.68 35.05 13.92 13.92 4.12 4.64 77.32 22.68
No.
%
No.
17 38 50 40 33 77 6 145 116
% 6.51 14.56 19.16 15.33 12.64 29.5 2.3 55.56 44.44
1992 9 32 59 55 67 67 5 155 139
1995 8 27 71 79 81 111 4 185 196
% 4 17 27 17 31 39 3 65 73
1991
1994 1.3 6.7 19.37 19.74 23.28 28.86 0.74 47.11 52.89
1984 % 7.47 16.09 20.69 17.24 14.94 20.11 3.45 61.49 38.51
1987
1990 % 2.49 18.91 19.4 9.95 17.91 29.85 1.49 50.75 49.25
1993 No.
No.
1986 %
25 60 81 49 58 76 3 215 137
1983 % 13.08 13.08 28.04 14.02 14.95 15.89 0.93 68.22 31.78
% 3.06 10.88 20.07 18.71 22.79 22.79 1.7 52.72 47.28
1996 2.1 7.09 18.64 20.73 21.26 29.13 1.05 48.56 51.44
10 23 80 97 129 137 1 210 267
% 2.1 4.82 16.77 20.34 27.04 28.72 0.21 44.03 55.97
ONE-YEAR TRANSITION MATRICES Source: Standard & Poor's, February 1997 1981 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 85 204 485 276 229 86 13
AAA 89.41 1.96 0 0 0 0 0
AA 10.59 88.24 4.54 0 0 0 0
A 0 9.31 88.04 3.99 0.87 1.16 0
Rating at year end (%) BBB BB B 0 0 0 0 0 0 6.39 0.21 0 89.13 4.71 0 5.24 59.39 30.57 0 4.65 82.56 0 0 7.69
CCC 0 0 0 0 0.44 3.49 84.62
D 0 0 0 0 0 2.33 0
NR 0 0.49 0.82 2.17 3.49 5.81 7.69
1982 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 85 220 480 298 168 161 16
AAA 92.94 0.45 0 0.34 0 0 0
AA 4.71 90 4.38 0.34 0.6 0 0
A 2.35 5.91 83.33 3.02 0 0.62 0
Rating at year end (%) BBB BB B 0 0 0 0.45 0.45 0 9.38 0.63 0 79.53 9.06 0.34 2.38 73.21 8.93 0.62 2.48 75.16 0 0 6.25
CCC 0 0 0 0 0 4.35 62.5
D 0 0 0.42 0.34 4.17 3.11 18.75
NR 0 2.73 1.88 7.05 10.71 13.66 12.5
1983 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 95 239 455 303 174 155 18
AAA 76.84 0.42 0.66 0 0 0 0
AA 20 91.21 4.4 0.66 0.57 0 0
A 1.05 5.86 87.47 6.27 1.15 0 0
Rating at year end (%) BBB BB B 0 0 0 0.84 0 0 3.96 0.66 0 80.53 4.95 0.99 2.87 72.99 11.49 0.65 3.23 78.71 5.56 0 16.67
CCC 0 0 0 0 0 0.65 77.78
D 0 0 0 0.33 1.15 4.52 0
NR 2.11 1.67 2.86 6.27 9.77 12.26 0
1984 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 90 288 470 301 176 183 21
AAA 71.11 1.39 0 0 0 0 0
AA 25.56 93.06 2.34 0.33 0 0 0
A 1.11 3.82 91.28 10.3 1.14 0 0
Rating at year end (%) BBB BB 0 0 1.04 0 3.62 0.43 77.41 5.98 7.95 80.68 1.09 4.92 0 0
B 0 0 0.21 1.99 5.11 84.7 0
CCC 0 0 0 0 0 0.55 80.95
D 0 0 0 0.66 0.57 3.83 14.29
NR 2.22 0.69 2.13 3.32 4.55 4.92 4.76
1985 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 72 320 501 286 202 210 21
AAA 93.06 0.31 0.2 0 0 0 0
AA 4.17 84.69 2 0.7 0 0 0
A 0 9.06 87.03 8.39 0.99 0.95 0
Rating at year end (%) BBB BB B 0 0 0 2.19 0 1.25 6.99 1.2 0 76.57 6.64 4.2 4.46 74.75 10.4 0 2.38 83.33 0 0 33.33
CCC 0 0.31 0 0 1.49 0.48 57.14
D 0 0 0 0 1.49 6.19 9.52
NR 2.78 2.19 2.59 3.5 6.44 6.67 0
Chapter 11 slides, page 17
1986 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 94 346 574 319 239 295 20
AAA 90.43 1.16 0.17 0 0 0 0
AA 6.38 88.15 5.57 0 0 0 0
A 0 5.2 75.61 6.27 0.42 0 0
Rating at year end (%) BBB BB B 0 0 0 0.87 0 0.58 8.54 1.39 1.57 74.92 8.15 2.82 7.11 73.22 6.28 0.34 4.07 66.78 0 0 0
CCC 0 0 0 0.31 1.67 10.51 70
D 0 0 0.17 0.31 1.26 8.14 20
NR 3.19 4.05 6.97 7.21 10.04 10.17 10
1987 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 114 360 518 340 275 368 65
AAA 88.6 1.39 0 0 0.36 0 0
AA 6.14 86.39 1.54 0.59 0 0 0
A 0 5.56 83.59 5 0 0.82 0
Rating at year end (%) BBB BB B 0.88 0 0 0.56 0 0 5.21 0.39 1.16 78.24 5.88 2.65 6.91 69.45 8 0 5.16 73.91 1.54 1.54 7.69
CCC 0 0 0 0 0 2.45 60
D 0 0 0 0 0 3.26 7.69
NR 4.39 6.11 8.11 7.65 15.27 14.4 21.54
1988 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 125 360 513 351 296 426 58
AAA 88 1.67 0 0 0 0 0
AA 4 82.78 1.36 0.57 0 0.23 0
A 2.4 10.28 87.72 9.12 1.01 0 0
Rating at year end (%) BBB BB B 0 1.6 0 1.94 0.56 0.28 4.87 0.97 0.58 74.36 4.56 2.28 7.09 71.28 7.43 0.47 4.46 72.54 3.45 3.45 8.62
CCC 0 0 0 0.57 2.03 3.05 48.28
D 0 0 0 0 1.01 3.76 22.41
NR 4 2.5 4.48 8.55 10.14 15.49 13.79
1989 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 133 351 575 358 290 425 55
AAA 88.72 0.85 0 0 0 0 0
AA 8.27 88.6 1.39 0 0 0.24 0
A 0.75 7.41 85.57 7.54 1.03 0 1.82
Rating at year end (%) BBB BB B 0 0 0 0 0 0 6.09 2.43 0.35 77.09 5.03 1.12 11.72 66.21 6.55 0 7.06 68.94 0 1.82 0
CCC 0 0 0 0.84 0.69 4.47 43.64
D 0 0 0.17 0.56 1.03 3.29 25.45
NR 2.26 3.13 4 7.82 12.76 16 27.27
1990 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 126 369 589 365 291 378 51
AAA 96.03 0.54 0 0 0 0 1.96
AA 3.17 85.64 2.04 0 0 0.53 0
A 0 12.47 84.89 3.84 0.69 0 0
Rating at year end (%) BBB BB B 0 0 0 0 0 0 7.3 1.7 0.17 84.66 4.93 1.1 5.5 65.64 9.28 0.53 2.91 65.87 0 1.96 3.92
CCC 0 0 0 0 3.44 5.56 56.86
D 0 0 0 0.27 3.09 8.2 29.41
NR 0.79 1.36 3.9 5.21 12.37 16.4 5.88
Chapter 11 slides, page 18
1991 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 137 368 606 388 248 293 68
AAA 90.51 0 0.17 0 0 0 0
AA 8.76 90.22 0.83 1.03 0 0 0
A 0.73 7.34 90.43 4.38 0 0 0
Rating at year end (%) BBB BB B 0 0 0 0 0 0 6.44 0.17 0 83.51 6.19 0.77 8.06 72.58 8.47 0 5.12 68.26 1.47 4.41 5.88
CCC 0 0 0 0 1.61 3.75 45.59
D 0 0 0 0.26 2.42 12.97 30.88
NR 0 2.45 1.98 3.87 6.85 9.9 11.76
1992 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 136 397 661 411 250 236 55
AAA 88.24 0.5 0 0 0 0 0
AA 8.82 89.42 0.91 0 0.4 0 0
A 0 7.3 91.83 5.11 0.4 0.42 0
Rating at year end (%) BBB BB B 0 0 0 0.76 0 0 3.18 0.91 0 85.4 3.89 0.73 10.8 73.6 4 1.27 10.59 63.98 0 3.64 12.73
CCC 0 0 0 0.24 2.4 5.08 47.27
D 0 0 0 0 0 7.63 29.09
NR 2.94 2.02 3.18 4.62 8.4 11.02 7.27
1993 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 131 406 718 460 300 238 50
AAA 90.84 0 0.28 0 0 0 0
AA 3.82 90.39 0.84 0 0.67 0 0
A 1.53 6.16 90.53 3.48 0.33 0 0
Rating at year end (%) BBB BB B 0 0 0 0.25 0 0 3.48 0 0 82.83 5.43 0 7.67 71.67 6.33 1.26 13.87 65.13 0 2 32
CCC 0 0 0 0 0.33 1.68 30
D 0 0 0 0 0.33 2.1 12
NR 3.82 3.2 4.87 8.26 12.67 15.97 24
1994 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 128 416 798 539 399 345 24
AAA 89.06 0.24 0 0 0 0 0
AA 7.03 89.9 0.88 0.19 0 0 0
A 0.78 7.93 91.73 3.53 0.25 0.29 4.17
Rating at year end (%) BBB BB B 0 0 0 0 0 0 4.01 0.13 0 88.5 2.04 0.19 7.52 82.46 3.01 0.29 6.09 81.45 0 0 4.17
CCC 0 0 0.13 0 0 2.9 45.83
D 0 0 0.13 0 0.25 2.32 16.67
NR 3.13 1.92 3.01 5.57 6.52 6.67 29.17
1995 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 126 434 955 625 447 409 27
AAA 92.86 0 0 0 0 0 0
AA 6.35 87.1 2.09 0.48 0 0 0
A 0 9.68 90.16 5.76 0.67 0 0
Rating at year end (%) BBB BB B 0 0 0 0.46 0 0 3.35 0.1 0 85.44 2.72 0 6.49 81.66 4.7 0.24 7.33 76.04 3.7 0 3.7
CCC 0 0 0 0 0 2.44 55.56
D 0 0 0 0.32 0.67 4.4 25.93
NR 0.79 2.76 4.29 5.28 5.82 9.54 11.11
1996 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 125 436 1013 678 494 444 29
AAA 84.8 0.23 0 0.15 0 0 0
AA 6.4 88.3 3.46 0 0 0 0
A 0.8 5.28 87.76 5.31 0.61 0.23 0
Rating at year end (%) BBB BB B 0 0 0 0 0 0 2.37 0.1 0 88.2 1.77 0.15 6.88 79.76 3.85 0.23 8.11 72.75 0 6.9 13.79
CCC 0 0 0 0 0.61 1.35 62.07
D 0 0 0 0 0.4 2.48 3.45
NR 8 6.19 6.32 4.42 7.89 14.86 13.79
Chapter 11 slides, page 19
Initial Rating AAA AA A BBB BB B CCC
Issuers 1665 5146 9305 5910 4230 4359 523
Chapter 11 slides, page 20
AAA 88.1 0.7 0.1 0.0 0.0 0.0 0.1
AA 8.4 88.3 2.5 0.3 0.1 0.1 0.0
Rating at year end (%), 15-year average, 1981-1996 A BBB BB B CCC 0.7 0.1 0.1 0.0 0.0 7.4 0.6 0.1 0.1 0.0 87.1 5.2 0.8 0.3 0.0 5.8 81.5 5.0 1.2 0.1 0.6 6.7 73.1 8.4 0.9 0.3 0.5 5.8 74.1 3.3 0.4 1.0 1.4 10.0 58.8
D 0.0 0.0 0.1 0.2 1.0 4.4 15.6
NR 2.7 2.7 4.0 5.8 9.1 11.6 12.6
TIME TO DEFAULT BY RATING CATEGORY Original rating AAA AA A BBB BB B CCC Totals
Defaults (units) 3 9 22 33 143 220 36 466
Average years from original rating 8 7.4 7.7 6.3 5 3.7 3 4.5
Last rating prior to D AAA AA A BBB BB B CCC Totals
Default (units) 0 0 0 6 21 185 254 466
Average years from last rating N.A. N.A. N.A. 1.5 3.1 2 0.7 1.3
Source: S&P “Ratings Performance 1996—Stability and Transition”
Chapter 11 slides, page 21
DEFAULT RATES BY INDUSTRY
Aerospace/Automotive/Capital goods/Metal Hightech/Computers/Office Consumer/Servicesector Leisure-time/Media Healthcare/Chemicals Forest/Buildingproducts/Home Energy/NaturalResources Utilities Telecommunications Transportation Financial Institutions Insurance/Realestate Totals
Period 1981-1996 No. No. of Default obligors defaults rate(%) 739 67 9.07 326 24 7.36 946 115 12.16 525 67 12.76 362 18 4.97 275 28 10.18 363 48 13.22 420 12 2.86 169 4 2.37 280 29 10.36 1100 37 3.36 399 17 4.26 5904 466 7.89
1996 No. of Default defaults rate(%) 1 0.14 1 0.31 8 0.85 4 0.76 1 0.28 0 0 1 0.28 0 0 0 0 1 0.36 0 0 0 0 17 0.29
Source: S&P, op. cit.
Chapter 11 slides, page 22
WEIGHTED-AVERAGE RECOVERY RATES PER $100 FACE VALUE ON DEFAULTED DEBT BY SENIORITY, 1978-95 Source : Altman & Kishore, "Almost Everything You Wanted to Know about Recoveries on Defaulted Bonds" Financial Analysts Journal , November/December 1996, pp. 57- 64
Default Year
Senior Secured Recovery Number Rate
1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 Total/average Median andard deviation
5 5 2 15 4 12 9 13 4 8 2 4 1 0 1 0 0 0 85
44.64 48.66 55.75 59.85 44.12 32.18 82.69 67.96 90.68 48.32 74.25 53.42 71.00 72.00 57.89 51.04 22.99
Chapter 11 slides, page 23
Senior Unsecured Recovery Number Rate
9 8 7 8 69 31 16 19 17 11 3 1 3 16 0 2 0 1 221
50.50 51.14 33.38 35.61 55.84 29.02 53.70 41.99 72.02 37.72 34.81 50.50 67.72 39.31 26.71 60.00 47.65 40.65 26.71
Senior Subordinated Recovery Number Rate
17 5 10 17 37 38 21 10 6 7 7 2 0 0 0 0 0 0 177
39.01 19.81 51.50 58.20 31.91 25.01 19.60 30.70 56.25 35.20 36.18 65.88 34.38 27.86 25.08
Subordinated Recovery Number Rate
1 3 9 22 38 24 30 20 4 30 15 7 4 4 0 2 1 0 214
20.00 37.04 28.38 49.13 24.30 18.83 23.95 35.27 35.25 33.39 41.45 44.68 41.79 32.91 16.63 31.00 31.34 31.96 22.42
Discount and Zero Coupon Recovery Number Rate
1 1 4 5 9 11 0 0 0 0 0 0 0 0 0 0 0 0 31
17.50 5.00 31.75 19.82 27.89 15.63 21.66 18.66 18.35
Table 2. Recovery Rates by industry: Defaulted Bonds, 1971-95 Source: Altman & Kishore, "Almost Everything You Wanted to Know about Recoveries on Defaulted Bonds" Financial Analysts Journal, November/December 1996, pp. 57- 64 SIC Code
492 150 616 290 730 491 560 790 280 470 350 300 500 610 380 770 609 520 390 260 270 330 360 200 208 496 420 620 100 410 998 450 483 720 220 590 780 540 650 320 340 130 580 630 530 533 370 602 510 800 482 701 230 570 632 670 138 310 250 603 240
Chapter 11 slides, page 24
Industry
Observations
Gas utilities Construction contracting Mortgage banks Petroleum and energy products Personal business service--cornpu Electric utilities Apparel and accessory stores Recreation services Chemicals and arned products Transportation services Machinery (except electric) Rubber and plastic products Wholesale and retail trade Finance comparees Instruments and related products Casino hotels Noncredit institutions Retail trade Manufacturing, miscellaneous Paper and allied products Printing and publishing Steel and metal products Electrical and electronic equipment Food and related--manufacturing Beverage bottlers Steam and air conditioning supply Trucking Financial services Mining Bus transit Diversified manufacturing Air transportation Radio and TV Broadcasting Laundry service Textile and mill products Retail miscellaneous Movie production Food stores Real estate Building materials Fabricated metal products Oil and gas driling Eating and dining places Insurance Department stores Variety stores Transportation equiprnent Commercial banks Wholesale trade--nondurable good Hospitals and nursing facilities Telegraph and related communicat Lodging places Apparel and related products Furniture, furnlshings and equipme Hospitals and medical services Investment funds and trusts Oil and gas field services Leather products Furniture Savings institutions Wood and related products
25 1 4 23 3 29 1 10 6 5 20 6 7 3 2 11 12 2 6 6 8 32 14 18 1 2 4 7 10 1 14 39 32 2 18 20 15 21 34 26 10 33 3 10 37 5 8 22 3 11 10 11 13 2 3 2 2 1 3 6 1
Recovery Rate Average Weighted
81.75 71.00 67.60 67.29 64.87 62.57 61.00 59.00 58.00 52.73 50.54 49.96 49.34 49.50 49.38 48.91 48.75 48.50 47.40 46.83 46.77 46.07 46.06 45.28 44.50 44.00 43.63 42.07 40.69 40.30 40.11 39.50 38.97 38.30 37.22 36.95 35.00 34.47 34.21 32.31 32.15 31.54 31.50 31.48 30.69 30.33 30.28 29.33 28.08 26.89 26.43 26.09 23.96 23.00 22.30 20.82 19.07 13.00 9.50 9.25 5.00
90.42 71.00 49.80 84.18 70.90 51.43 61.00 60.70 61.63 43.16 49.95 56.55 52.00 53.91 49.30 44.22 54.76 47.56 51.18 44.37 47.76 42.92 35.90 37.40 44.50 43.99 40.39 36.46 33.34 40.50 23.64 41.25 39.81 39.31 38.52 38.37 35.41 26.68 27.93 25.25 24.62 31.91 38.74 35.17 27.99 18.28 40.77 21.60 34.15 18.47 34.85 22.12 26.13 23.30 31.41 28.21 19.08 13.00 11.39 19.68 5.00
Table 3. Recovery Rates by Industry: Defaufted Bonds by Three-Digit SIC Code, 1971-95 Source: Altman & Kishore, "Almost Everything You Wanted to Know about Recoveries on Defaulted Bonds" Financial Analysts Journal, November/December 1996, pp. 57- 64 Recovery Rate
Industry
Public utilities Chemicals, petroleum, rubber and plastic products Machinery, instruments, and related products Services--business and personal Food and kindred products Wholesale and retail trade Diversified manufacturing Casino, hotel, and recreation Building materials, metals, and fabricated products Transportation and transportation equipment Communication, broadcasting, movies, printing, publishing Financial institutions Construction and real estate General merchandise stores Mining and petroleum drilling Textile and apparel products Wood, paper, and leather products Lodging, hospitals, and nursing facilities Total
Chapter 11 slides, page 25
Number of Observations
Average
56 35 36 14 18 12 20 21 68 52 65 66 35 89 45 31 11 22 696
70.47 62.73 48.74 46.23 45.28 44.00 42.29 40.15 38.76 38.42 37.08 35.69 35.27 33.16 33.02 31.66 29.77 26.49 41.00
SIC Code
490 280,290,300 350,360,380 470,632,720,730 200 500,510,520 390,998 770,790 320,330,340 370,410,420,450 270,480,780 600,610,620,630,670 150,650 530,540,560,570,580,000 100,103 220,230 240,250,260,310 700 through 890
Weighted Median observations Average
65.48 80.39 44.75 50.01 37.40 48.90 29.49 39.74 29.64 41.12 39.34 35.44 28.58 29.35 31.83 33.72 24.30 19.61 39.11
79.07 71.88 47.50 41.50 41.50 37.32 33.88 28.00 37.75 37.13 34.50 32.15 24.00 30.00 32.00 31.13 18.25 16.00 36.25
Standard Deviation Weighted
19.46 27.10 20.13 25.03 21.67 22.14 24.98 25.66 22.86 27.98 20.79 25.72 28.69 20.47 18.01 15.24 24.38 22.65 25.56
From Tom Wolfe, Bonfire of the Vanities, 1987. (On the origins of the bond markets of the 70s and 80s) ... They had Lyndon Johnson to thank. Ever so quietly, the U.S. had started printing money by the billions to finance the war in Vietnam. before anyone, even Johnson, knew what was happening, a worldwide inflation had begun. Everyone woke up to it when the Arabs suddenly jacked up oil prices in the early 1970s. In no time, markets of all sorts became heaving crap-shoots: gold, silver, copper, currencies, bank certificates, corporate notes--even bonds. For decades the bond business had been the bedridden giant of Wall Street. At firms such as Salomon Brothers, Morgan Stanley, Goldman Sachs and Pierce & Pierce, twice as much money had always changed hands on the bond market as on the stock market. But prices had budged by only pennies at a time, and mostly they went down. As Lopwitz put it, "The bond market has been going down every since the Battle of Midway." The Battle of Midway (Sherman had to look it up) was in the Second World War. The Pierce & Pierce bond department had consisted of only twenty souls, twenty rather dull souls knows as the Bond Bores. The less promising members of the firm were steered into bonds, where they could do no harm. Sherman resisted the thought that it had been even thus when he entered the bond department. Well, there was no more talk about Bond Bores these days . . . Oh no! Not at all! The bond market had caught fire, and experienced salesmen such as himself were all at once much in demand. All of a sudden, in investment houses all over Wall Street, the erstwhile Bond Bores were making so much money they took to congregating after work in a bar on Hanover square called Harry's to tell war stories . . . and assure one another this wasn't dumb luck but, rather, a surge of collective talent. Bonds now represented four-fifths of Pierce & Pierce's business, and the young hotshots, the Yalies, Harvards, and Stanfords, were desperate to get to the bond trading room of Pierce & Pierce.
Chapter 11 slides, page 26
"But what do you do?" asked Campbell. "Well, Sherman, how about it?" said his father with a big grin. I want to hear the answer to this myself. I've often asked myself what it is you fellows do exactly. Campbell, that's an excellent question." "Well, I deal in bonds, sweetheart. I buy them, I sell them, I …" "What are bonds? What is a deal?" "Explain it to me, too, Sherman," said his father. "I must have done five thousand leveraged purchase contracts, and I always fell asleep before I could figure out why anyone wanted the bonds." "Your grandfather's only joking, honey." He shot his father a sharp look. "A bond is a way of loaning people money. Let's say you want to build a road, and it's not a little road but a big highway, like the highway we took up to Maine last summer. Or you want to build a big hospital. Well, that requires a lot of money, more money than you could ever get by just going to a bank. So what you do is, you issue what are called bonds." "You build roads and hospitals, Daddy? That's what you do?" "No, I don't actually build them, sweetheart. I handle the bonds, and the bonds are what make it possible--" "You help build them?" "Well, in a way." "Which ones?" "Which ones?" "Well, not any one specifically." "The road to Maine?" Judy broke in. "Let me try. . . . Darling, Daddy doesn't build roads or hospitals, and he doesn't help build them, but he does handle the bonds for the people who raise the money." "Bonds?" "Yes. Just imagine that a bond is a slice of cake, and you didn't bake the cake, but every time you hand somebody a slice of the cake a tiny bit comes off, like a little crumb, and you can keep that." Judy was smiling, and so was Campbell, who seemed to realize that this was a joke, a kind of fairy tale based on what her daddy did.
Chapter 11 slides, page 27
"Little crumbs?" She said encouragingly. "Yes," said Judy. "or you have to imagine little crumbs, but a lot of little crumbs. If you pass around enough slices of cake, then pretty soon you have enough crumbs to make a gigantic cake." "For real life?" asked Campbell. "No, not for real life. You just have to imagine that." Judy looked to Sherman's father and mother for approval of this witty description of the bond business. They smiled, but uncertainly. "I'm not sure you're making it any clearer for Campbell," said Sherman. "My goodness . . . crumbs." He smile to show he knew this was only lunch-table banter. In fact . . . he was used to Judy's supercilious attitude toward Wall Street, but he was not happy about . . . crumbs. "You can call them crumbs if you want," said Sherman, trying not to sound testy, and failing. "Well, that's the best I can do," Judy said brightly. Then to his father and mother: "Investment banking is an unusual field. I don't know if there is any way you can explain it to anyone under twenty. Or perhaps under thirty."
Chapter 11 slides, page 28
WEB SITES Bonds On-Line: http://www.bonds-online.com Standard and Poors: http://www.ratings.standardpoor.com This is an excellent site with tons of information (even though some of the Adobe Acrobat files are screwed up!) Moody’s http://www.moodys.com Not nearly as good as S&P! Arthur Warga, www.uwm.edu:80/People/warga, Professor at U. of Wisconsin, Milwaukee who is building a data base on fixed income with Lehman Brothers
Chapter 11 slides, page 29
E D rd 1 tc ED ED
Note that rd is the expected cost of debt = the expected return promised return
Chapter 11 slides, page 1
Of course we could calculate the WACC in some other way. For example, when T = 0: r (U ) WACC
Chapter 11 slides, page 2
D 1 t c E D 1 E
re ( L) rf debt
SOME PRELIMINARIES
Can be computed from return data (see Chapter 11 of book for example for Boeing) There is no commercial source for bond betas (as far as we know?—see Arthur Warga’s web site and see article in Financial Management, Spring 1996) Can be imputed from the SML for debt, if we know the expected return
Chapter 11 slides, page 3
IMPUTING A BOND BETA Debt SML (reminder): E rd rf debt d E rm rf debt1 tc where E rd expected return on debt security rf debt return on riskless debt E rm return on equity market portfolio tc marginal corporate tax rate Covr~m, r~d debt beta wrt equity market portfolio d Var r~ m
If we know expected return on debt we can calculate the debt A 3 market risk premium 4 risk-free rate 5 corporate tax rate, tc 6 slope of SML 7 8 expected bond return 9 10 implied beta
Chapter 11 slides, page 4
B C D E F 8.40% <-- Brealey and Myers 6.69% <-- AAA bond rate, 10 year corporates 36% 10.81% <-- market risk premium + tc*risk-free 8.00% 0.1212 <-- (B8-B4)/B6
BETAS FOR SELECTED VANGUARD FUNDS Note: The source is Vanguard's Web site--http://majestic1.vanguard.com This is not meant to be a scientific study!
Year Ended December 31 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 1977 beta wrt SP
Chapter 11 slides, page 5
Vanguard Index 500 Portfolio 22.9% 37.4% 1.2% 9.9% 7.4% 30.2% -3.3% 31.4% 16.2% 4.7% 18.1% 31.2% 6.2% 21.3% 21.0% -5.2% 31.9% 18.0% 5.9% -7.8%
Lehman Bond Index Portfolio
Municipal Bond High Long-Term LimitedYield U.S. Short-Term High-Yield Term Corporate Treasury Federal Municipals
VBIF 3.6% 18.2% -2.7% 9.7% 7.1% 15.2% 8.6% 13.6% 7.4% 1.1%
VMBF 4.1% 8.6% 0.1% 6.3% 6.4% 9.5% 7.0% 8.1% 6.4%
VFISF 9.5% 19.2% -1.7% 18.2% 14.2% 29.0% -5.8% 1.9% 13.6% 2.7% 16.9% 22.0% 7.9% 15.1% 27.5% 9.4% 3.4% 5.5%
VUSTX -1.3% 30.1% -7.0% 16.8% 7.4% 17.4% 5.8% 17.9% 9.2% -2.9%
VSGBX 4.8% 12.3% -0.9% 7.0% 6.2% 12.2% 9.3% 11.3% 5.7%
VWAHX 4.50% 18.10% -5.10% 12.70% 9.90% 14.70% 5.90% 11.10% 13.80% -1.60% 19.70% 21.70% 9.70% 10.40% 35.90% -8.80% -11.40% -1.20%
0.3374
0.1129
0.3587
0.5843
0.1908
0.3572
GNMA VFIIIX 5.2% 17.0% -1.0% 5.9% 6.8% 16.8% 10.3% 14.8% 8.8% 2.1% 11.7% 20.7% 14.0% 9.7% 31.6% 4.8%
0.3590
Lehman 3-year Municipal Bond Index 4.4% 8.9% 0.7% 6.2% 6.4% 10.3% 7.2% 7.7% 4.6%
0.1137
VANGUARD HIGH-YIELD MUNICIPALS 40%
y = 0.3572x + 0.0293 R2 = 0.156
Municipals
30% 20% 10% 0% -10%-10% 0% -20%
Chapter 11 slides, page 6
10%
20%
SP 500 Fund
30%
40%
CALCULATING THE EXPECTED RETURN OF A BOND—A SIMPLE EXAMPLE F = face value of the bond P = price of bond C = annual coupon rate of the bond = probability that the bond will not default at end of year = fraction of bond’s value bondholders collect upon default The expected end-of-year cash flow is: E CF 1 C F 1 F The expected return from the bond (i.e., the cost of debt): E rd
E CF 1 C F 1 F 1 1 P P
Chapter 11 slides, page 7
SIMPLE SPREADSHEET EXAMPLE
1 2 3 4 5 6 7 8 9 10 11
A B C D EXPECTED RETURN ON A ONE-YEAR BOND with an adjustment for default probability Assumes that face value equals 1 coupon rate market price
Expected CF Expected return
Chapter 11 slides, page 8
E
16% 0.98 90% <-- Non-default probability 80% <-- Recovery percentage 112.400% <-- =B7*(1+B5)+(1-B7)*B8 14.694% <-- =(B7*(1+B5-B8)+B8)/B6-1
CALCULATING RISK ADJUSTED EXPECTED BOND RETURNS A MORE GENERAL MODEL Start with a 3 period bond which has the following characteristics: C is the bond coupon rate P is the bond price F is the bond’s face value n is the probability of non-default in period n, conditional on non-default in periods 1, …, n-1. n is the recovery ratio in period n
Chapter 11 slides, page 9
The associated payoffs are given by the following tree: C+F C
C
-P
Chapter 11 slides, page 10
0
0
0
The probabilities on the payoff tree look like:
1
At every node the upper branch is the non-default probability. Multiplying these two trees node by node gives the expected bond payoffs. Taking the IRR gives the expected return on the bond. Formal model comes later.
Chapter 11 slides, page 11
Note that it’s possible that the expected return on the yield curves below are all equal to the AAA rate (this could happen with risk neutrality):
Chapter 11 slides, page 12
Long-Term Senior Debt Rating Symbols Investment-Grade Ratings
Speculative-Grade Ratings
S&P and others
Moody’s
Interpretation
S&P and others
Moody’s
Interpretation
AAA
Aaa
Highest Quality
BB+ BB BB-
Ba1 Ba2 Ba3
Likely to fulfill obligations; ongoing uncertainty
AA+ AA AA-
Aa1 Aa2 AA3
High Quality
B+ B B-
B1 B2 B3
High-risk obligations
A+ A A-
A1 A2 A3
Strong Payment Capacity
CCC+ CCC CCC-
Caa
Current vulnerability to default or in default (Moody’s)
BBB+ BBB BBB-
Baa1 Baa2 Baa3
Adequate Payment Capacity
C D
Ca D
In bankruptcy or default, or other marked shortcomings
Chapter 11 slides, page 13
Spreads between Corporate Bonds and U.S. Treasuries 1973-1987 Averages Rating Basis Points AAA 43 AA 73 A 99 BBB 166 BB 299 B 404 CCC 724 Note: Based on equally weighted averages of monthly spreads per rating category. Spreads for BB and B represent data for 1979-1987 only; spreads for CCC, data for 1982-1987 only. Source: Altman, Journal of Finance, 1989 Chapter 11 slides, page 14
Chapter 11 slides, page 15
RATING CLASSIFICATION OF NEW ISSUERS 1981 No. AAA AA A BBB BB B CCC Investment Grade Speculative Grade
5 9 20 9 14 19 1 43 34
1982 % 6.49 11.69 25.97 11.69 18.18 24.68 1.3 55.84 44.16
No. 14 14 30 15 16 17 1 73 34
1985 No. AAA AA A BBB BB B CCC Investment Grade Speculative Grade
7.1 17.05 23.01 13.92 16.48 21.59 0.85 61.08 38.92
No. 24 17 45 31 54 136 15 117 205
1989 No. AAA AA A BBB BB B CCC Investment Grade Speculative Grade
5 38 39 20 36 60 3 102 99
AAA AA A BBB BB B CCC Investment Grade Speculative Grade
Chapter 11 slides, page 16
7 36 104 106 125 155 4 253 284
13 28 36 30 26 35 6 107 67
No.
%
No.
13 34 44 18 17 10 8 109 35
% 7.45 5.28 13.98 9.63 16.77 42.24 4.66 36.34 63.66
No.
% 9.03 23.61 30.56 12.5 11.81 6.94 5.56 75.69 24.31
No.
% 2.16 8.43 32.75 16.67 16.67 22.35 0.98 60 40
No.
18 32 40 35 63 112 10 125 185
11 43 167 85 85 114 5 306 204
No.
11 44 68 27 27 8 9 150 44
2.9 12.32 19.57 12.32 22.46 28.26 2.17 47.1 52.9
1988 % 5.81 10.32 12.9 11.29 20.32 36.13 3.23 40.32 59.68
No.
% 5.67 22.68 35.05 13.92 13.92 4.12 4.64 77.32 22.68
No.
%
No.
17 38 50 40 33 77 6 145 116
% 6.51 14.56 19.16 15.33 12.64 29.5 2.3 55.56 44.44
1992 9 32 59 55 67 67 5 155 139
1995 8 27 71 79 81 111 4 185 196
% 4 17 27 17 31 39 3 65 73
1991
1994 1.3 6.7 19.37 19.74 23.28 28.86 0.74 47.11 52.89
1984 % 7.47 16.09 20.69 17.24 14.94 20.11 3.45 61.49 38.51
1987
1990 % 2.49 18.91 19.4 9.95 17.91 29.85 1.49 50.75 49.25
1993 No.
No.
1986 %
25 60 81 49 58 76 3 215 137
1983 % 13.08 13.08 28.04 14.02 14.95 15.89 0.93 68.22 31.78
% 3.06 10.88 20.07 18.71 22.79 22.79 1.7 52.72 47.28
1996 2.1 7.09 18.64 20.73 21.26 29.13 1.05 48.56 51.44
10 23 80 97 129 137 1 210 267
% 2.1 4.82 16.77 20.34 27.04 28.72 0.21 44.03 55.97
ONE-YEAR TRANSITION MATRICES Source: Standard & Poor's, February 1997 1981 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 85 204 485 276 229 86 13
AAA 89.41 1.96 0 0 0 0 0
AA 10.59 88.24 4.54 0 0 0 0
A 0 9.31 88.04 3.99 0.87 1.16 0
Rating at year end (%) BBB BB B 0 0 0 0 0 0 6.39 0.21 0 89.13 4.71 0 5.24 59.39 30.57 0 4.65 82.56 0 0 7.69
CCC 0 0 0 0 0.44 3.49 84.62
D 0 0 0 0 0 2.33 0
NR 0 0.49 0.82 2.17 3.49 5.81 7.69
1982 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 85 220 480 298 168 161 16
AAA 92.94 0.45 0 0.34 0 0 0
AA 4.71 90 4.38 0.34 0.6 0 0
A 2.35 5.91 83.33 3.02 0 0.62 0
Rating at year end (%) BBB BB B 0 0 0 0.45 0.45 0 9.38 0.63 0 79.53 9.06 0.34 2.38 73.21 8.93 0.62 2.48 75.16 0 0 6.25
CCC 0 0 0 0 0 4.35 62.5
D 0 0 0.42 0.34 4.17 3.11 18.75
NR 0 2.73 1.88 7.05 10.71 13.66 12.5
1983 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 95 239 455 303 174 155 18
AAA 76.84 0.42 0.66 0 0 0 0
AA 20 91.21 4.4 0.66 0.57 0 0
A 1.05 5.86 87.47 6.27 1.15 0 0
Rating at year end (%) BBB BB B 0 0 0 0.84 0 0 3.96 0.66 0 80.53 4.95 0.99 2.87 72.99 11.49 0.65 3.23 78.71 5.56 0 16.67
CCC 0 0 0 0 0 0.65 77.78
D 0 0 0 0.33 1.15 4.52 0
NR 2.11 1.67 2.86 6.27 9.77 12.26 0
1984 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 90 288 470 301 176 183 21
AAA 71.11 1.39 0 0 0 0 0
AA 25.56 93.06 2.34 0.33 0 0 0
A 1.11 3.82 91.28 10.3 1.14 0 0
Rating at year end (%) BBB BB 0 0 1.04 0 3.62 0.43 77.41 5.98 7.95 80.68 1.09 4.92 0 0
B 0 0 0.21 1.99 5.11 84.7 0
CCC 0 0 0 0 0 0.55 80.95
D 0 0 0 0.66 0.57 3.83 14.29
NR 2.22 0.69 2.13 3.32 4.55 4.92 4.76
1985 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 72 320 501 286 202 210 21
AAA 93.06 0.31 0.2 0 0 0 0
AA 4.17 84.69 2 0.7 0 0 0
A 0 9.06 87.03 8.39 0.99 0.95 0
Rating at year end (%) BBB BB B 0 0 0 2.19 0 1.25 6.99 1.2 0 76.57 6.64 4.2 4.46 74.75 10.4 0 2.38 83.33 0 0 33.33
CCC 0 0.31 0 0 1.49 0.48 57.14
D 0 0 0 0 1.49 6.19 9.52
NR 2.78 2.19 2.59 3.5 6.44 6.67 0
Chapter 11 slides, page 17
1986 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 94 346 574 319 239 295 20
AAA 90.43 1.16 0.17 0 0 0 0
AA 6.38 88.15 5.57 0 0 0 0
A 0 5.2 75.61 6.27 0.42 0 0
Rating at year end (%) BBB BB B 0 0 0 0.87 0 0.58 8.54 1.39 1.57 74.92 8.15 2.82 7.11 73.22 6.28 0.34 4.07 66.78 0 0 0
CCC 0 0 0 0.31 1.67 10.51 70
D 0 0 0.17 0.31 1.26 8.14 20
NR 3.19 4.05 6.97 7.21 10.04 10.17 10
1987 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 114 360 518 340 275 368 65
AAA 88.6 1.39 0 0 0.36 0 0
AA 6.14 86.39 1.54 0.59 0 0 0
A 0 5.56 83.59 5 0 0.82 0
Rating at year end (%) BBB BB B 0.88 0 0 0.56 0 0 5.21 0.39 1.16 78.24 5.88 2.65 6.91 69.45 8 0 5.16 73.91 1.54 1.54 7.69
CCC 0 0 0 0 0 2.45 60
D 0 0 0 0 0 3.26 7.69
NR 4.39 6.11 8.11 7.65 15.27 14.4 21.54
1988 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 125 360 513 351 296 426 58
AAA 88 1.67 0 0 0 0 0
AA 4 82.78 1.36 0.57 0 0.23 0
A 2.4 10.28 87.72 9.12 1.01 0 0
Rating at year end (%) BBB BB B 0 1.6 0 1.94 0.56 0.28 4.87 0.97 0.58 74.36 4.56 2.28 7.09 71.28 7.43 0.47 4.46 72.54 3.45 3.45 8.62
CCC 0 0 0 0.57 2.03 3.05 48.28
D 0 0 0 0 1.01 3.76 22.41
NR 4 2.5 4.48 8.55 10.14 15.49 13.79
1989 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 133 351 575 358 290 425 55
AAA 88.72 0.85 0 0 0 0 0
AA 8.27 88.6 1.39 0 0 0.24 0
A 0.75 7.41 85.57 7.54 1.03 0 1.82
Rating at year end (%) BBB BB B 0 0 0 0 0 0 6.09 2.43 0.35 77.09 5.03 1.12 11.72 66.21 6.55 0 7.06 68.94 0 1.82 0
CCC 0 0 0 0.84 0.69 4.47 43.64
D 0 0 0.17 0.56 1.03 3.29 25.45
NR 2.26 3.13 4 7.82 12.76 16 27.27
1990 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 126 369 589 365 291 378 51
AAA 96.03 0.54 0 0 0 0 1.96
AA 3.17 85.64 2.04 0 0 0.53 0
A 0 12.47 84.89 3.84 0.69 0 0
Rating at year end (%) BBB BB B 0 0 0 0 0 0 7.3 1.7 0.17 84.66 4.93 1.1 5.5 65.64 9.28 0.53 2.91 65.87 0 1.96 3.92
CCC 0 0 0 0 3.44 5.56 56.86
D 0 0 0 0.27 3.09 8.2 29.41
NR 0.79 1.36 3.9 5.21 12.37 16.4 5.88
Chapter 11 slides, page 18
1991 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 137 368 606 388 248 293 68
AAA 90.51 0 0.17 0 0 0 0
AA 8.76 90.22 0.83 1.03 0 0 0
A 0.73 7.34 90.43 4.38 0 0 0
Rating at year end (%) BBB BB B 0 0 0 0 0 0 6.44 0.17 0 83.51 6.19 0.77 8.06 72.58 8.47 0 5.12 68.26 1.47 4.41 5.88
CCC 0 0 0 0 1.61 3.75 45.59
D 0 0 0 0.26 2.42 12.97 30.88
NR 0 2.45 1.98 3.87 6.85 9.9 11.76
1992 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 136 397 661 411 250 236 55
AAA 88.24 0.5 0 0 0 0 0
AA 8.82 89.42 0.91 0 0.4 0 0
A 0 7.3 91.83 5.11 0.4 0.42 0
Rating at year end (%) BBB BB B 0 0 0 0.76 0 0 3.18 0.91 0 85.4 3.89 0.73 10.8 73.6 4 1.27 10.59 63.98 0 3.64 12.73
CCC 0 0 0 0.24 2.4 5.08 47.27
D 0 0 0 0 0 7.63 29.09
NR 2.94 2.02 3.18 4.62 8.4 11.02 7.27
1993 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 131 406 718 460 300 238 50
AAA 90.84 0 0.28 0 0 0 0
AA 3.82 90.39 0.84 0 0.67 0 0
A 1.53 6.16 90.53 3.48 0.33 0 0
Rating at year end (%) BBB BB B 0 0 0 0.25 0 0 3.48 0 0 82.83 5.43 0 7.67 71.67 6.33 1.26 13.87 65.13 0 2 32
CCC 0 0 0 0 0.33 1.68 30
D 0 0 0 0 0.33 2.1 12
NR 3.82 3.2 4.87 8.26 12.67 15.97 24
1994 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 128 416 798 539 399 345 24
AAA 89.06 0.24 0 0 0 0 0
AA 7.03 89.9 0.88 0.19 0 0 0
A 0.78 7.93 91.73 3.53 0.25 0.29 4.17
Rating at year end (%) BBB BB B 0 0 0 0 0 0 4.01 0.13 0 88.5 2.04 0.19 7.52 82.46 3.01 0.29 6.09 81.45 0 0 4.17
CCC 0 0 0.13 0 0 2.9 45.83
D 0 0 0.13 0 0.25 2.32 16.67
NR 3.13 1.92 3.01 5.57 6.52 6.67 29.17
1995 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 126 434 955 625 447 409 27
AAA 92.86 0 0 0 0 0 0
AA 6.35 87.1 2.09 0.48 0 0 0
A 0 9.68 90.16 5.76 0.67 0 0
Rating at year end (%) BBB BB B 0 0 0 0.46 0 0 3.35 0.1 0 85.44 2.72 0 6.49 81.66 4.7 0.24 7.33 76.04 3.7 0 3.7
CCC 0 0 0 0 0 2.44 55.56
D 0 0 0 0.32 0.67 4.4 25.93
NR 0.79 2.76 4.29 5.28 5.82 9.54 11.11
1996 Static Pool Initial Rating AAA AA A BBB BB B CCC
Issuers 125 436 1013 678 494 444 29
AAA 84.8 0.23 0 0.15 0 0 0
AA 6.4 88.3 3.46 0 0 0 0
A 0.8 5.28 87.76 5.31 0.61 0.23 0
Rating at year end (%) BBB BB B 0 0 0 0 0 0 2.37 0.1 0 88.2 1.77 0.15 6.88 79.76 3.85 0.23 8.11 72.75 0 6.9 13.79
CCC 0 0 0 0 0.61 1.35 62.07
D 0 0 0 0 0.4 2.48 3.45
NR 8 6.19 6.32 4.42 7.89 14.86 13.79
Chapter 11 slides, page 19
Initial Rating AAA AA A BBB BB B CCC
Issuers 1665 5146 9305 5910 4230 4359 523
Chapter 11 slides, page 20
AAA 88.1 0.7 0.1 0.0 0.0 0.0 0.1
AA 8.4 88.3 2.5 0.3 0.1 0.1 0.0
Rating at year end (%), 15-year average, 1981-1996 A BBB BB B CCC 0.7 0.1 0.1 0.0 0.0 7.4 0.6 0.1 0.1 0.0 87.1 5.2 0.8 0.3 0.0 5.8 81.5 5.0 1.2 0.1 0.6 6.7 73.1 8.4 0.9 0.3 0.5 5.8 74.1 3.3 0.4 1.0 1.4 10.0 58.8
D 0.0 0.0 0.1 0.2 1.0 4.4 15.6
NR 2.7 2.7 4.0 5.8 9.1 11.6 12.6
TIME TO DEFAULT BY RATING CATEGORY Original rating AAA AA A BBB BB B CCC Totals
Defaults (units) 3 9 22 33 143 220 36 466
Average years from original rating 8 7.4 7.7 6.3 5 3.7 3 4.5
Last rating prior to D AAA AA A BBB BB B CCC Totals
Default (units) 0 0 0 6 21 185 254 466
Average years from last rating N.A. N.A. N.A. 1.5 3.1 2 0.7 1.3
Source: S&P “Ratings Performance 1996—Stability and Transition”
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DEFAULT RATES BY INDUSTRY
Aerospace/Automotive/Capital goods/Metal Hightech/Computers/Office Consumer/Servicesector Leisure-time/Media Healthcare/Chemicals Forest/Buildingproducts/Home Energy/NaturalResources Utilities Telecommunications Transportation Financial Institutions Insurance/Realestate Totals
Period 1981-1996 No. No. of Default obligors defaults rate(%) 739 67 9.07 326 24 7.36 946 115 12.16 525 67 12.76 362 18 4.97 275 28 10.18 363 48 13.22 420 12 2.86 169 4 2.37 280 29 10.36 1100 37 3.36 399 17 4.26 5904 466 7.89
1996 No. of Default defaults rate(%) 1 0.14 1 0.31 8 0.85 4 0.76 1 0.28 0 0 1 0.28 0 0 0 0 1 0.36 0 0 0 0 17 0.29
Source: S&P, op. cit.
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WEIGHTED-AVERAGE RECOVERY RATES PER $100 FACE VALUE ON DEFAULTED DEBT BY SENIORITY, 1978-95 Source : Altman & Kishore, "Almost Everything You Wanted to Know about Recoveries on Defaulted Bonds" Financial Analysts Journal , November/December 1996, pp. 57- 64
Default Year
Senior Secured Recovery Number Rate
1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 Total/average Median andard deviation
5 5 2 15 4 12 9 13 4 8 2 4 1 0 1 0 0 0 85
44.64 48.66 55.75 59.85 44.12 32.18 82.69 67.96 90.68 48.32 74.25 53.42 71.00 72.00 57.89 51.04 22.99
Chapter 11 slides, page 23
Senior Unsecured Recovery Number Rate
9 8 7 8 69 31 16 19 17 11 3 1 3 16 0 2 0 1 221
50.50 51.14 33.38 35.61 55.84 29.02 53.70 41.99 72.02 37.72 34.81 50.50 67.72 39.31 26.71 60.00 47.65 40.65 26.71
Senior Subordinated Recovery Number Rate
17 5 10 17 37 38 21 10 6 7 7 2 0 0 0 0 0 0 177
39.01 19.81 51.50 58.20 31.91 25.01 19.60 30.70 56.25 35.20 36.18 65.88 34.38 27.86 25.08
Subordinated Recovery Number Rate
1 3 9 22 38 24 30 20 4 30 15 7 4 4 0 2 1 0 214
20.00 37.04 28.38 49.13 24.30 18.83 23.95 35.27 35.25 33.39 41.45 44.68 41.79 32.91 16.63 31.00 31.34 31.96 22.42
Discount and Zero Coupon Recovery Number Rate
1 1 4 5 9 11 0 0 0 0 0 0 0 0 0 0 0 0 31
17.50 5.00 31.75 19.82 27.89 15.63 21.66 18.66 18.35
Table 2. Recovery Rates by industry: Defaulted Bonds, 1971-95 Source: Altman & Kishore, "Almost Everything You Wanted to Know about Recoveries on Defaulted Bonds" Financial Analysts Journal, November/December 1996, pp. 57- 64 SIC Code
492 150 616 290 730 491 560 790 280 470 350 300 500 610 380 770 609 520 390 260 270 330 360 200 208 496 420 620 100 410 998 450 483 720 220 590 780 540 650 320 340 130 580 630 530 533 370 602 510 800 482 701 230 570 632 670 138 310 250 603 240
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Industry
Observations
Gas utilities Construction contracting Mortgage banks Petroleum and energy products Personal business service--cornpu Electric utilities Apparel and accessory stores Recreation services Chemicals and arned products Transportation services Machinery (except electric) Rubber and plastic products Wholesale and retail trade Finance comparees Instruments and related products Casino hotels Noncredit institutions Retail trade Manufacturing, miscellaneous Paper and allied products Printing and publishing Steel and metal products Electrical and electronic equipment Food and related--manufacturing Beverage bottlers Steam and air conditioning supply Trucking Financial services Mining Bus transit Diversified manufacturing Air transportation Radio and TV Broadcasting Laundry service Textile and mill products Retail miscellaneous Movie production Food stores Real estate Building materials Fabricated metal products Oil and gas driling Eating and dining places Insurance Department stores Variety stores Transportation equiprnent Commercial banks Wholesale trade--nondurable good Hospitals and nursing facilities Telegraph and related communicat Lodging places Apparel and related products Furniture, furnlshings and equipme Hospitals and medical services Investment funds and trusts Oil and gas field services Leather products Furniture Savings institutions Wood and related products
25 1 4 23 3 29 1 10 6 5 20 6 7 3 2 11 12 2 6 6 8 32 14 18 1 2 4 7 10 1 14 39 32 2 18 20 15 21 34 26 10 33 3 10 37 5 8 22 3 11 10 11 13 2 3 2 2 1 3 6 1
Recovery Rate Average Weighted
81.75 71.00 67.60 67.29 64.87 62.57 61.00 59.00 58.00 52.73 50.54 49.96 49.34 49.50 49.38 48.91 48.75 48.50 47.40 46.83 46.77 46.07 46.06 45.28 44.50 44.00 43.63 42.07 40.69 40.30 40.11 39.50 38.97 38.30 37.22 36.95 35.00 34.47 34.21 32.31 32.15 31.54 31.50 31.48 30.69 30.33 30.28 29.33 28.08 26.89 26.43 26.09 23.96 23.00 22.30 20.82 19.07 13.00 9.50 9.25 5.00
90.42 71.00 49.80 84.18 70.90 51.43 61.00 60.70 61.63 43.16 49.95 56.55 52.00 53.91 49.30 44.22 54.76 47.56 51.18 44.37 47.76 42.92 35.90 37.40 44.50 43.99 40.39 36.46 33.34 40.50 23.64 41.25 39.81 39.31 38.52 38.37 35.41 26.68 27.93 25.25 24.62 31.91 38.74 35.17 27.99 18.28 40.77 21.60 34.15 18.47 34.85 22.12 26.13 23.30 31.41 28.21 19.08 13.00 11.39 19.68 5.00
Table 3. Recovery Rates by Industry: Defaufted Bonds by Three-Digit SIC Code, 1971-95 Source: Altman & Kishore, "Almost Everything You Wanted to Know about Recoveries on Defaulted Bonds" Financial Analysts Journal, November/December 1996, pp. 57- 64 Recovery Rate
Industry
Public utilities Chemicals, petroleum, rubber and plastic products Machinery, instruments, and related products Services--business and personal Food and kindred products Wholesale and retail trade Diversified manufacturing Casino, hotel, and recreation Building materials, metals, and fabricated products Transportation and transportation equipment Communication, broadcasting, movies, printing, publishing Financial institutions Construction and real estate General merchandise stores Mining and petroleum drilling Textile and apparel products Wood, paper, and leather products Lodging, hospitals, and nursing facilities Total
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Number of Observations
Average
56 35 36 14 18 12 20 21 68 52 65 66 35 89 45 31 11 22 696
70.47 62.73 48.74 46.23 45.28 44.00 42.29 40.15 38.76 38.42 37.08 35.69 35.27 33.16 33.02 31.66 29.77 26.49 41.00
SIC Code
490 280,290,300 350,360,380 470,632,720,730 200 500,510,520 390,998 770,790 320,330,340 370,410,420,450 270,480,780 600,610,620,630,670 150,650 530,540,560,570,580,000 100,103 220,230 240,250,260,310 700 through 890
Weighted Median observations Average
65.48 80.39 44.75 50.01 37.40 48.90 29.49 39.74 29.64 41.12 39.34 35.44 28.58 29.35 31.83 33.72 24.30 19.61 39.11
79.07 71.88 47.50 41.50 41.50 37.32 33.88 28.00 37.75 37.13 34.50 32.15 24.00 30.00 32.00 31.13 18.25 16.00 36.25
Standard Deviation Weighted
19.46 27.10 20.13 25.03 21.67 22.14 24.98 25.66 22.86 27.98 20.79 25.72 28.69 20.47 18.01 15.24 24.38 22.65 25.56
From Tom Wolfe, Bonfire of the Vanities, 1987. (On the origins of the bond markets of the 70s and 80s) ... They had Lyndon Johnson to thank. Ever so quietly, the U.S. had started printing money by the billions to finance the war in Vietnam. before anyone, even Johnson, knew what was happening, a worldwide inflation had begun. Everyone woke up to it when the Arabs suddenly jacked up oil prices in the early 1970s. In no time, markets of all sorts became heaving crap-shoots: gold, silver, copper, currencies, bank certificates, corporate notes--even bonds. For decades the bond business had been the bedridden giant of Wall Street. At firms such as Salomon Brothers, Morgan Stanley, Goldman Sachs and Pierce & Pierce, twice as much money had always changed hands on the bond market as on the stock market. But prices had budged by only pennies at a time, and mostly they went down. As Lopwitz put it, "The bond market has been going down every since the Battle of Midway." The Battle of Midway (Sherman had to look it up) was in the Second World War. The Pierce & Pierce bond department had consisted of only twenty souls, twenty rather dull souls knows as the Bond Bores. The less promising members of the firm were steered into bonds, where they could do no harm. Sherman resisted the thought that it had been even thus when he entered the bond department. Well, there was no more talk about Bond Bores these days . . . Oh no! Not at all! The bond market had caught fire, and experienced salesmen such as himself were all at once much in demand. All of a sudden, in investment houses all over Wall Street, the erstwhile Bond Bores were making so much money they took to congregating after work in a bar on Hanover square called Harry's to tell war stories . . . and assure one another this wasn't dumb luck but, rather, a surge of collective talent. Bonds now represented four-fifths of Pierce & Pierce's business, and the young hotshots, the Yalies, Harvards, and Stanfords, were desperate to get to the bond trading room of Pierce & Pierce.
Chapter 11 slides, page 26
"But what do you do?" asked Campbell. "Well, Sherman, how about it?" said his father with a big grin. I want to hear the answer to this myself. I've often asked myself what it is you fellows do exactly. Campbell, that's an excellent question." "Well, I deal in bonds, sweetheart. I buy them, I sell them, I …" "What are bonds? What is a deal?" "Explain it to me, too, Sherman," said his father. "I must have done five thousand leveraged purchase contracts, and I always fell asleep before I could figure out why anyone wanted the bonds." "Your grandfather's only joking, honey." He shot his father a sharp look. "A bond is a way of loaning people money. Let's say you want to build a road, and it's not a little road but a big highway, like the highway we took up to Maine last summer. Or you want to build a big hospital. Well, that requires a lot of money, more money than you could ever get by just going to a bank. So what you do is, you issue what are called bonds." "You build roads and hospitals, Daddy? That's what you do?" "No, I don't actually build them, sweetheart. I handle the bonds, and the bonds are what make it possible--" "You help build them?" "Well, in a way." "Which ones?" "Which ones?" "Well, not any one specifically." "The road to Maine?" Judy broke in. "Let me try. . . . Darling, Daddy doesn't build roads or hospitals, and he doesn't help build them, but he does handle the bonds for the people who raise the money." "Bonds?" "Yes. Just imagine that a bond is a slice of cake, and you didn't bake the cake, but every time you hand somebody a slice of the cake a tiny bit comes off, like a little crumb, and you can keep that." Judy was smiling, and so was Campbell, who seemed to realize that this was a joke, a kind of fairy tale based on what her daddy did.
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"Little crumbs?" She said encouragingly. "Yes," said Judy. "or you have to imagine little crumbs, but a lot of little crumbs. If you pass around enough slices of cake, then pretty soon you have enough crumbs to make a gigantic cake." "For real life?" asked Campbell. "No, not for real life. You just have to imagine that." Judy looked to Sherman's father and mother for approval of this witty description of the bond business. They smiled, but uncertainly. "I'm not sure you're making it any clearer for Campbell," said Sherman. "My goodness . . . crumbs." He smile to show he knew this was only lunch-table banter. In fact . . . he was used to Judy's supercilious attitude toward Wall Street, but he was not happy about . . . crumbs. "You can call them crumbs if you want," said Sherman, trying not to sound testy, and failing. "Well, that's the best I can do," Judy said brightly. Then to his father and mother: "Investment banking is an unusual field. I don't know if there is any way you can explain it to anyone under twenty. Or perhaps under thirty."
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WEB SITES Bonds On-Line: http://www.bonds-online.com Standard and Poors: http://www.ratings.standardpoor.com This is an excellent site with tons of information (even though some of the Adobe Acrobat files are screwed up!) Moody’s http://www.moodys.com Not nearly as good as S&P! Arthur Warga, www.uwm.edu:80/People/warga, Professor at U. of Wisconsin, Milwaukee who is building a data base on fixed income with Lehman Brothers
Chapter 11 slides, page 29
