Week 12 Lecture - TOPICSCOVERED Default&BondRatings NotCovered&NotExaminable:ValueatRisk TheBondContract RepaymentProvisions DebtCovenants

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TOPICS COVERED Predicting the Probability of Default The Bond Contract Security and Seniority Repayment Provisions Debt Covenants Convertible Bonds and Warrants Project Finance Innovation in the Bond Market
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DEFAULTING DEBT LEVELS $ Millions Face value of defaulting debt
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CREDIT DEFAULT SWAP DATA Spread, % Credit default swaps insure holders of corporate bonds against default. Dow Jones indexes of spreads on default swaps measure the annual insurance premium. CDS spread (= “Insurance premium” ) should match underlying yield spreads on bonds
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BOND RATINGS AND  DEFAULT Rating at Time of Issue 1 Year after issue 5 Years after Issue 10 Years after Issue AAA 0 0.1 0.6 AA 0 0.3 0.9 A 0 0.6 1.9 BBB 0.3 3.1 6.6 BB 1.2 12.7 24 B 5.9 30.5 44.8 CCC 30.4 56 67.7 Percentage Defaulting Within Default rates of corporate bonds 1981-2005 by S&P’s rating at time of issue Ratings do forecast default rates
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BOND RATINGS AND  FINANCIAL RATIOS Ratio AAA AA A BBB BB B CCC EBIT interest cover * 23.8 19.5 8 4.7 2.5 1.2 0.4 return on capital % 27.6 27 17.5 13.4 11.3 8.7 3.2 Total debt/capital % 22.9 28.3 37.5 42.5 53.7 75.9 113.5 * Earnings before interst and tax divided by interest Three years of median ratio data by bond rating (2002– 2004). Ratings reflect financial characteristics
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PREDICTING DEFAULT A comparison of financial statements from firms that have gone bankrupt with those firms that have not gone bankrupt reveals information valuable to the lending decision. Financial ratios of 544 failing and non-failing firms. Traditional credit analysis is based on financial statement analysis. But credit risk models can be used instead. ..
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DEFAULT PREDICTION MODELS Predicting Default  - William Beaver, Maureen McNichols,  and Jung-Wu Rhie, studied defaulting and non-defaulting  firms and concluded the chance of failing during the next year relative to the chance of not failing was best estimated by the  following equation: L failure of chance Relative / 346 . / 307 . 2 192 . 1 445 . 6 failure) of chance (relative Log e s liabilitie EBITDA assets s liabilitie ROA = - + - - = Many possible approaches, various statistical techniques (MDA, Logit, survival analysis) , recursive partitioning, neural networks. But very difficult to achieve high levels of accuracy.
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CREDIT ANALYSIS Credit analysis is only worth while if the  expected savings exceed the cost. Don’t undertake a full credit analysis unless the 
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This note was uploaded on 08/22/2011 for the course FINC 2011 taught by Professor Craigmellare during the Three '10 term at University of Sydney.

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Week 12 Lecture - TOPICSCOVERED Default&BondRatings NotCovered&NotExaminable:ValueatRisk TheBondContract RepaymentProvisions DebtCovenants

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