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Lecture 2 Script

This document discusses corporate debt and credit risk. It begins by explaining that credit ratings agencies assign ratings to corporate debt issues to indicate their default risk, ranging from safe triple-A rated bonds to bonds in default. Below investment grade bonds, also called high-yield or junk bonds, historically have had higher default rates than investment grade bonds. However, some investment grade bonds are later downgraded as issuers run into trouble. The document then discusses how default and recovery rates are key statistics used to measure credit risk, noting that default rates vary significantly over time and are correlated with economic downturns.

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Ashish Malhotra
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13 views

Lecture 2 Script

This document discusses corporate debt and credit risk. It begins by explaining that credit ratings agencies assign ratings to corporate debt issues to indicate their default risk, ranging from safe triple-A rated bonds to bonds in default. Below investment grade bonds, also called high-yield or junk bonds, historically have had higher default rates than investment grade bonds. However, some investment grade bonds are later downgraded as issuers run into trouble. The document then discusses how default and recovery rates are key statistics used to measure credit risk, noting that default rates vary significantly over time and are correlated with economic downturns.

Uploaded by

Ashish Malhotra
Copyright
© © All Rights Reserved
Available Formats
Download as TXT, PDF, TXT or read online on Scribd
You are on page 1/ 3

PROFESSOR: There are many types of contracts

that involve credit risk, including loans to individuals


and small businesses, mortgages, sovereign debt,
and corporate debt.
Although the general principles that we'll be discussing
applied to all of these, the main emphasis
will be on models that are most directly
applicable to corporate debt.
So I want to start with a few general observations
about corporate debt and the nature of default risk.
The first has to do with credit ratings.
As you probably know, rating agencies
like Moody's, Standard & Poor's, and Fitch
assign ratings to corporate debt issues that give investors
some idea of the default risk that's
associated with a particular issuer or security.
There are many levels of ratings,
ranging from very safe triple-A rated securities down to D
rated securities that are in default.
A major distinction based on ratings
is the difference between investment grade
and below investment grade.
Below investment grade securities
are also described as speculative, high-yield,
or junk.
High-yield bonds historically have
had much higher default rates than investment grade bonds.
However, many high-yield bonds were originally
investment grade and they were downgraded as their issuers ran
into trouble.
These are the so-called fallen angels.
Hence buying an investment grade bond
isn't a guarantee that you won't eventually
experience default losses.
However, it's interesting that high-yield bonds have performed
well historically in the sense of having realized relatively
high risk adjusted returns.
Regarding the nature of default risk,
it's also important to understand
that only a small percentage of corporate bonds
will ever default. Nevertheless, bond prices are significantly
affected by the possibility that default losses will occur
and the fact that the likelihood of loss
vary significantly over time.
While default events are rare, rating changes
are much more frequent.
Those are a manifestation of default risk
and can be described as downgrade risk.
A bond that's downgraded when the market isn't expecting it
is likely to experience a price drop and conversely
for a bond that's upgraded.
There are variants of events that themselves don't directly
cause default but that can significantly
change its likelihood.
For instance, a legal ruling that significantly
changes the profitability of a corporation.
Liquidity, that is the ability to buy or sell a bond quickly
with minimal price impact, is typically lower
for riskier bonds, hence credit risk and liquidity
risk tend to be related.
Default and recovery rates are key statistics
used to quantify credit risk.
The default rate is the probability
that a default will occur.
It's usually stated on an annual basis.
What constitutes a default event depends on whose definition
is being used.
Rating agencies have stated criteria
for what determines a default and then
contracts like credit default swaps
also will specify what they treat as a default event.
Now, the recovery rate is the percentage of the amount owed,
usually principal plus any accrued interest,
that will be received by the creditor
in the event of a default. Recoveries
are calculated in various ways.
One approach is to estimate the present value of the cash that
will be eventually recovered, such as when
the remaining assets of the firm are liquidated.
Alternatively, sometimes the market price
of the bond right after default is announced
is used as a proxy for the present value of recoveries.
Note that the recovery rate is one minus the loss rate.
And the loss rate is also called the loss given default.
Default and recovery rates can vary significantly
over the life of a bond.
For example, a bond issued to build a nuclear power plant
may have a much higher probability of default
and a lower expected recovery rate during the first few years
it's outstanding and the plant is still under construction.
Once the reactor is up and running and producing revenues,
it's much less likely that there will be a default.
That sort of situation can also give rise
to what's called a term structure of default
and recovery rates.
In the model we're going to look at,
for simplicity, we'll assume that those rates are
held constant, but the model is easily
modified to incorporate a term structure of rates.

This graph illustrates the magnitude of default rates


over time for investment grade, speculative grade,
and overall debt issuances for the period from 1981 to 2018.
I want to highlight several observations here.
First, there are clearly large fluctuations
in default rates over time with spikes during recessions.
Those fluctuations are driven by speculative grade debt.
As shown here, those spikes and default rates
occurred during the 1991, 2001, and 2008 recessions.
Second, even in recessions, default rates
are close to zero for investment grade debt.
The overall default rate is also quite low.
Over this time period, it only touched 4%
in the severe recession of 2008-2009 and for most periods
it's below 2%.
Importantly, the positive covariance
of default rates with the economic downturns imparts
market risk to corporate debt, hence risky corporate debt
has a positive beta and the cost of that market risk
is reflected in bond prices.

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