- Likelihood of receiving the coupon and the principle
- Likelihood of receiving them on the stipulated time
- … in accordance to the debt conditions
These agencies also help sort out rating categories, giving you a relative understanding of debt against another debt issue.
However, you will only see a rating – A, AA, AAA. You will never see headlines reporting quantitative risk measures. So it is hard to understand the difference between AAA and B. An economist will use broader categories to differentiate between the investment grade bond and the rest. So ratings don’t add a lot of value.
There are quite few instances when credit agencies failed to evaluate correctly. For example, in March 2008, Moody’s Investors Services and Standard & Poor’s announced the downgrading of the ratings of the renowned investment bank Bear Sterns. Two days later, the U.S Department of the Treasure and the Federal Reserve Board started negotiating the sale of the bank to JP Morgan Chase. Bear Stern, which was one of the largest banks, only two years before that used to own assets of 350.5 billion dollars and total capital of 66.7 billion. The bank was sold for only 1.2 billion dollars by the end of March.
Although the blame was put on several sides, the U.S. credit rating agencies continue to be the number one aim, since they didn’t predict the collapse that was about to happen.
Another example is the Enron Scandal, which refers to the collapse of Enron Corporation, an American energy, commodities, and services company based in Houston, Texas, in December 2001. The company filed for bankruptcy few days after the downgrading of its credit rating.
I think it is more important for us to think about using ratios. People use ratios for equities. They say overgeneralize that a low PE is better than a higher PE ratio. I have doubts on these statements. There are too many assumptions in earnings estimation and growth assumptions. But it is better than comparing ratings.
Can we use interest coverage ratios? To pay down debt, we have to first consider the amount of money sitting in the firm’s bank account that can be drawn down to pay interest. So that’s the first level of assurance.
Can we use yield spreads? I think so. Yield spreads tell me the incremental rate over the risk free equivalent treasury bond. It tells me 2 things
- My expected loss in a default
- The premium I’m paying for credit and liquid risks
Please note that a firm would have been considered to have defaulted on payments when they fail to make payments on time. Being late for one day is default. So when you read on the news that shipping companies and banks fail to honor their debt obligations on time and in specific ways, they have defaulted. It happens frequently.
Credit risk is the risk that your borrower’s credit quality may change. If you gave someone $1000 for 2 years and in return, you get $100 per year and $1000 at the end of the 2 year period, you pray that this person doesn’t get into financial trouble. If he loses his job, his credit quality will change. But he may or may not decide to return you the money. This is credit risk. If he does not lose his job, but decides not to return you the money, this is default risk.
I often find that people are confused by credit, default and liquidity risk. Liquidity risk has nothing to do with borrower not returning money. If you bought a debt issuance and want to sell it on capital markets, you will face liquidity risks. You don’t know if you can liquidate this instrument quickly and in the right value. If you sell a $100 worth of stock for $50 and you have difficulty finding a buyer, the liquidity risk you are exposed to is tremendous.
Measuring bond value risk
How do we measure bond risk? Can we measure bond price like we measure stock price? Yes we can. But it is not as intuitive as volatility of yield spreads. I explained earlier that yield spreads contains information on bond risk factors. In addition, rates are inversely related to bond price. So it is better to measure bond risk by yield spread volatility.
For small changes in yields, bond price is directly negatively correlated. For bond portfolios, it’s not so clear cut. Bond convexity comes in to play – a term to describe the impact of different bonds with different payouts at different times. Every bond has a different modified duration.
So how is bond risks related to firm wide credit risk? Firms issue long term debt, these form the largest part of liabilities.
Layman understanding of credit safety
As a summary, a non-financial expert should only look at 2 things
- Cash flow. The higher the cash flow the higher the interest coverage. I prefer to look into its operating cashflow. Are they making money from core operations? Some moneys sell assets to generate pseudo signs of positive cashflow.
- EBITDA. You can also use earnings – add back non-cash charges.
Forget about ratings. They give you some information, but it’s clearly no adequate. Recall before the 2008 recession, rating agencies gave some of those banks that collapsed investment grade ratings.