Question

Elaborate on default risk of a firm. That is, talk about the definition the ratings and the factors, which go into the ratings. How do ratings and yields to maturity relate? How does time and bankruptcy risk relate? How is default risk different from systematic risk?

Answer 1

Elaborate on default risk of a firm. That is, talk about the definition the ratings and the factors, which go into the ratings. How do ratings and yields to maturity relate? How does time and bankruptcy risk relate? How is default risk different from systematic risk?

1. Default risk is the chance that companies or individuals will be unable to make the required payments on their debt obligations. Lenders and investors are exposed to default risk in virtually all forms of credit extensions. To mitigate the impact of default risk, lenders often charge rates of return that correspond the debtor's level of default risk. A higher level of risk leads to a higher required return.

Default risk can change as a result of broader economic changes or changes in a company's financial situation. Economic recession can impact the revenues and earnings of many companies, influencing their ability to make interest payments on debt and, ultimately, repay the debt itself. Companies may face factors such as increased competition and lower pricing power, resulting in a similar financial impact. Entities need to generate sufficient net income and cash flow to mitigate default risk.

In the event of a default, investors may lose out on periodic interest payments and their investment in the bond. A default could result in a 100% loss on investment.

1. Default risk can be gauged using standard measurement tools, including FICO scores for consumer credit, and credit ratings for corporate and government debt issues. Credit ratings for debt issues are provided by nationally recognized statistical rating organizations (NRSROs), such as Standard & Poor's (S&P), Moody's and Fitch Ratings.
2. The credit scores established by the ratings agencies can be grouped into two categories: investment grade and non-investment grade, or junk. Investment-grade debt is considered to have low default risk and is generally more sought-after by investors. Conversely, non-investment grade debt offers higher yields than safer bonds, but it also comes with a significantly higher chance of default.

While the grading scales used by the ratings agencies are slightly different, most debt is graded similarly. Any bond issue given a AAA, AA, A or BBB rating by S&P is considered investment grade. Anything rated BB and below is considered non-investment grade.

1. One of the biggest factors that affect bond rating is a company's credit risk. Credit or default risk primarily refers to the company's ability to pay back its debts to its creditors. These debts include principal and interest payments on loans, dividends and insurance payments. Because a bond is a debt instrument, when investors purchase bonds, they become creditors of the company from which they bought the bond. A company that is less likely to default on its outstanding debt, meaning it demonstrates a high level of creditworthiness, generally has a higher credit rating. As the creditworthiness of a company decreases, the bond rating falls.
2. Like most investment instruments, bonds are forward looking. Credit rating agencies conduct extensive research as to the plausible future performance of a bond. This assessment affects a company's bond rating. Companies that have a history of good financial standing and demonstrate that its current financial standing is unlikely to change generally have high credit ratings.

How do ratings and yields to maturity relate?

A "AAA" high grade bond offers more security and a lower profit potential (lower yield to maturity) than a B- speculative bond(higher YTM). Yield to maturity can be quite useful for estimating whether or not buying a bond is a good investment. An investor will often determine a required yield, or the return on a bond that will make the bond worthwhile, which may vary from investor to investor. Once an investor has determined the YTM of a bond he or she is considering buying, the investor can compare the YTM with the required yield to determine if the bond is a good buy.

How does time and bankruptcy risk relate?

Bankruptcy risk describes the likelihood that a firm will become insolvent because of its inability to service its debt. A firm can fail financially because of cash flow problems resulting from inadequate sales and high operating expenses. To address the cash flow problems, the firm might increase its short-term borrowings. If the situation does not improve, the firm is at risk of insolvency or bankruptcy. Many investors consider a firm's bankruptcy risk prior to making equity or bond investment decisions. Agencies such as Moody's and Standard & Poor's attempt to assess risk by giving bond ratings. Also called "insolvency risk."

Insolvency occurs when a firm cannot meet its contractual financial obligations as they come due. Obligations might include interest and principal payments on debt, payments on accounts payable and income taxes. More specifically, a firm is technically insolvent if it cannot meet its current obligations as they come due, despite the value of its assets exceeding the value of its liabilities. A firm is legally insolvent if the value of its assets is less than the value of its liabilities. A firm is bankrupt if it is unable to pay its debts and files a bankruptcy petition.

Solvency is measured with a liquidity ration called the "current ratio," a comparison between current assets (including cash on hand and any assets that could be converted into cash within 12 months such as inventory, receivables and supplies) and current liabilities (debts that are due within the next 12 months, such as interest and principal payments on debt serviced, payroll and payroll taxes).

Hence if the current liabilities (debt due in coming 12 months) exceeds the current assets then the firm is considered as technically insolvent.

default risk VS. systematic risk

Systematic Risk- systematic risk (often called aggregate risk or undiversifiable risk) is vulnerability to events which affect aggregate outcomes such as broad market returns, total economy-wide resource holdings, or aggregate income. In many contexts, events like earthquakes and major weather catastrophes pose aggregate risks that affect not only the distribution but also the total amount of resources. Systematic or aggregate risk arises from market structure or dynamics which produce shocks or uncertainty faced by all agents in the market; such shocks could arise from government policy, international economic forces, or acts of nature.

In contrast, specific risk (sometimes called residual risk or idiosyncratic risk) is risk to which only specific agents or industries are vulnerable (and is uncorrelated with broad market returns). Due to the idiosyncratic nature of unsystematic risk, it can be reduced or eliminated through diversification.

Default or Credit Risk- the risk that a borrower will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is particularly concerning to investors who hold bonds in their portfolios. Government bonds, especially those issued by the federal government, have the least amount of default risk and, as such, the lowest returns. Corporate bonds, on the other hand, tend to have the highest amount of default risk, but also higher interest rates.

Systematic risk will affect the entire market where as default risk only affects an investor who hold a debt instrument of a company that is likely to default