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investing in bonds below investment grade. Thus, the market for investment grade bonds
tends to be wider and deeper than that for bonds below that grade. Second, firms that are
not rated investment grade have a tougher time when they try to raise new funding and
they also pay much higher issuance costs when they do. In fact, until the early 1980s,
firms below investment grade often could not issue new bonds. The perception that

19 In the early 1980s, Michael Milken and Drexel Burnham that created the junk bond market, allowing for
original issuance of junk bonds. They did this primarily to facilitate hostile takeovers by the raiders of the

they are exposed to default risk also creates a host of other costs including tighter
supplier credit and debt covenants.

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 that is assigned to a company's 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 cashflows. While a multitude of financial
ratios exist, table 3.2 summarizes some of the key ratios that are used to measure default
Table 3.2: Financial Ratios used to measure Default Risk
Ratio Description
Pretax Interest = (Pretax Income from Continuing Operations + Interest
Coverage Expense)
/ Gross Interest
EBITDA Interest = EBITDA/ Gross Interest
Funds from =(Net Income from Continuing Operations + Depreciation)
Operations / Total / Total Debt
Free Operating = (Funds from Operations - Capital Expenditures - Change in
Cashflow/ Total Working Capital) / Total Debt
Pretax Return on = (Pretax Income from Continuing Operations + Interest
Permanent Capital Expense)
/ (Average of Beginning of the year and End of the year of long
and short term debt, minority interest and Shareholders Equity)
Operating = (Sales - COGS (before depreciation) - Selling Expenses -
Income/Sales (%) Administrative Expenses - R&D Expenses) / Sales
Long Term Debt/ = Long Term Debt / (Long Term Debt + Equity)
Total = Total Debt / (Total Debt + Equity)
There is a strong relationship between the bond rating a company receives and its
performance on these financial ratios. Table 3.3 provides a summary of the median ratios
from 1998 to 2000 for different S&P ratings classes for manufacturing firms.

Table 3.3: Financial Ratios by Bond Rating: 1998- 2000
EBIT interest cov. (x) 17.5 10.8 6.8 3.9 2.3 1.0 0.2
EBITDA interest cov. 21.8 14.6 9.6 6.1 3.8 2.0 1.4
Funds flow/total debt 105.8 55.8 46.1 30.5 19.2 9.4 5.8
Free oper. cash 55.4 24.6 15.6 6.6 1.9 “4.5 -14.0
flow/total debt (%)
Return on capital (%) 28.2 22.9 19.9 14.0 11.7 7.2 0.5
Oper.income/sales 29.2 21.3 18.3 15.3 15.4 11.2 13.6
Long-term 15.2 26.4 32.5 41.0 55.8 70.7 80.3
debt/capital (%)
Total Debt/ Capital 26.9 35.6 40.1 47.4 61.3 74.6 89.4
Number of firms 10 34 150 234 276 240 23

Note that the pre-tax interest coverage ratio 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 cashflows that are 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 bring subjective judgments into the final mix. Thus, a
firm that performs poorly on financial ratios but is expected to improve its performance
dramatically over the next period may receive a higher rating than that justified by its
current financials. For most firms, however, the financial ratios should provide a
reasonable basis for guessing at the bond rating.

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. 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. The difference between the interest

rate on a bond with default risk and a default-free government bond is called 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. Table 3.4 summarizes default
spreads in early 2004 for ten-year bonds in each ratings class (using S&P ratings) and the
market interest rates on these bonds, based upon a treasury bond rate of 4%.

Table 3.4: Default Spreads for Ratings Classes: January 2004
Rating Default Spread Interest rate on bond
AAA 0.30% 4.30%
AA 0.50% 4.50%
A+ 0.70% 4.70%
A 0.85% 4.85%
A- 1.00% 5.00%
BBB 1.50% 5.50%
BB 3.50% 7.50%
B+ 4.25% 8.25%
B 5.00% 9.00%
B- 8.25% 12.25%
CCC 12.50% 16.50%
CC 14.00% 18.00%
C 16.00% 20.00%
D 20.00% 24.00%

Source: bondsonline.com
Table 3.4 provides default spreads at a point in time, but default spreads not only vary
across time but they can vary for bonds with the same rating but different maturities.
From observation, the default spread for corporate bonds of a given ratings class seems to
increase with the maturity of the bond. In Figure 3.10 we present the default spreads
estimated for an AAA, BBB and CCC rated bond for maturities ranging from 1 to 10
years in January 2004.

Figure 3.10: Default Spreads by Maturity



Spread over Treasury Bond Rate





1 yr 2 yr 3 yr 5 yr 7 yr 10 yr

Aaa/AAA Baa2/BBB B

For the AAA and BBB ratings, the default spread widen for the longer maturities. For the
B rated bonds, the spreads widen as we go from 1 to 3 year maturities but narrow after
than. Why might this be? It is entirely possible that this reflects where we are in the
economic cycle. In early 2004, there were many cyclical firms that were in trouble
because of the recession of the prior 2 years. If these firms survive in the short term (say
3 years), improving earnings will reduce default risk in future years.
The default spreads presented in Table 3.4, after a good year for the stock markets
and signs of an economic pickup, were significantly lower than the default spreads a year
earlier. This phenomenon is not new. Historically, default spreads for every ratings class
have increased during recessions and decreased during economic booms. The practical
implication of this phenomenon is that default spreads for bonds have to be re-estimated
at regular intervals, especially if the economy shifts from low to high growth or vice
A final point worth making here is that everything that has been said about the
relationship between interest rates and bond ratings could be said more generally about
interest rates and default risk. The existence of ratings is a convenience that makes the

assessment of default risk a little easier for us when analyzing companies. In its absence,
we would still have to assess default risk on our own and come up with estimates of the
default spread we would charge if we were lending to a firm.

ratings.xls: There is a dataset on the web that summarizes default spreads by
bond rating class for the most recent period.

In Practice: Ratings Changes and Interest Rates
The rating assigned to a company can change at the discretion of the ratings
agency. The change is usually triggered by a change in a firm™s operating health, a new
security issue by the firm or by new borrowing. Other things remaining equal, ratings will
drop if the operating performance deteriorates or if the firm borrows substantially more
and improve if it reports better earnings or if it raises new equity. In either case, though,
the ratings agency is reacting to news that the rest of the market also receives. In fact,
ratings agencies deliberate before making ratings changes, often putting a firm on a credit
watch list before changing its ratings. Since markets can react instantaneously, it should
come as no surprise that bond prices often decline before a ratings drop and increase
before a ratings increase. In fact, studies indicate that much of the bond price reaction to
deteriorating credit quality precedes a ratings drop.
This does not mean that there is no information in a ratings change. When ratings
are changed, the market still reacts but the reactions tend to be small. The biggest service
provided by ratings agencies may be in providing a measure of default risk that is
comparable across hundreds of rated firms, thus allowing bond investors a simple way of
categorizing their potential investments.

Risk, as we define it in finance, is measured based upon deviations of actual
returns on an investment from its' expected returns. There are two types of risk. The first,
which we call equity risk, arises in investments where there are no promised cash flows,
but there are expected cash flows. The second,, default risk, arises on investments with
promised cash flows.

On investments with equity risk, the risk is best measured by looking at the
variance of actual returns around the expected returns, with greater variance indicating
greater risk. This risk can be broken down into risk that affects one or a few investments,
which we call firm specific risk, and risk that affects many investments, which we refer
to as market risk. When investors diversify, they can reduce their exposure to firm
specific risk. By assuming that the investors who trade at the margin are well diversified,
we conclude that the risk we should be looking at with equity investments is the market
risk. The different models of equity risk introduced in this chapter share this objective of
measuring market risk, but they differ in the way they do it. In the capital asset pricing
model, exposure to market risk is measured by a market beta, which estimates how much
risk an individual investment will add to a portfolio that includes all traded assets. The
arbitrage pricing model and the multi-factor model allow for multiple sources of market
risk and estimate betas for an investment relative to each source. Regression or proxy
models for risk look for firm characteristics, such as size, that have been correlated with
high returns in the past and use these to measure market risk. In all these models, the risk
measures are used to estimate the expected return on an equity investment. This expected
return can be considered the cost of equity for a company.
On investments with default risk, risk is measured by the likelihood that the
promised cash flows might not be delivered. Investments with higher default risk should
have higher interest rates, and the premium that we demand over a riskless rate is the
default premium. For most US companies, default risk is measured by rating agencies in
the form of a company rating; these ratings determine, in large part, the interest rates at
which these firms can borrow. Even in the absence of ratings, interest rates will include a
default premium that reflects the lenders™ assessments of default risk. These default-risk
adjusted interest rates represent the cost of borrowing or debt for a business.

Problems and Questions

1. The following table lists the stock prices for Microsoft from 1989 to 1998. The company did
not pay any dividends during the period
Year Price
1989 $ 1.20
1990 $ 2.09
1991 $ 4.64
1992 $ 5.34
1993 $ 5.05
1994 $ 7.64


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