10-1 Chapter 10 Default Risk. 10-2 zEvery bond issue has a contract called the bond indenture among three parties – the bondholders, the issuer, and the.
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Slide 1
10-1 Chapter 10 Default Risk
Slide 2
10-2 zEvery bond issue has a contract called the bond indenture
among three parties the bondholders, the issuer, and the trustee.
zThe trustee is appointed to protect the interests of the
bondholders and must be independent of the issuing firm. Bond
Indenture
Slide 3
10-3 zCorporate bond issues have protective covenants. These
are restrictions on the issuer to prevent the issuer from taking
advantage of the bondholders. zTypical protective covenants include
restrictions on yIssuance of additional debt. yDividends. yMergers.
yDisposition of assets. Protective Covenants
Slide 4
10-4 zDefault is a violation of any part of the bond indenture
agreement. zSome defaults involved nonpayment of interest or
principal. zOther defaults involve violation of some protective
covenant in the bond indenture. Default
Slide 5
10-5 zThe trustee acts on behalf of the bondholders in the
event of default. If there is a nonpayment of cash, 100 percent
agreement of the bondholders is required for the trustee to take
action. For other defaults, complete agreement of the bondholders
is not necessary for the trustee to act.
10-7 Fishermen acting individually$100,000 now Fishermen acting
in concert$25,000 annually Common Pool Problem
Slide 8
10-8 zCourt costs. zAttorneys fees. zLost profit opportunities.
Who would lend money to or buy products from firms in bankruptcy?
Costs of Bankruptcy
Slide 9
10-9 zFinancial distress is defined as a condition in which
operating income is less than fixed charges payable to creditors.
zA firm in financial distress may request protection of the
bankruptcy court. Financial Distress
Slide 10
10-10 zHowever, some firms in financial distress may consider
other courses of action. ySale of assets. yRaise equity. yMerge.
yBorrow more. Reschedule old loans. yUse depreciation. yGovernment
assistance.
Slide 11
10-11 zAccording to the rule of absolute priority, claimants
are paid in the following order. Each category must be paid in full
before the next can receive any payments. zCourts, tax obligations,
employees, secured creditors, unsecured creditors, preferred
stockholders, equity stockholders. Rule of Absolute Priority
Slide 12
10-12 zThe rule of absolute priority applies in liquidations,
which represent about 10 percent of corporate bankruptcies. zIn
reorganizations, which represent probably 90 percent of corporate
bankruptcies, the rule of absolute priority is not followed.
Slide 13
10-13 zIn a reorganization, the bankruptcy courts have set up a
complicated set of procedures for trying to arrive at a
reorganization. Stockholders have the first chance to present a
reorganization plan, followed by creditors. If the parties cannot
agree, the bankruptcy court has the right to impose a
reorganization plan. Reorganization Procedures
Slide 14
10-14 zWhile a firm is in bankruptcy, the firms securities
typically continue to trade, although there may be some
interruptions of trading. Investing in either the bonds or the
stocks of firms in bankruptcy is extremely risky. The returns can
be very poor or very good.
Slide 15
10-15 zDebentures are bonds which have a general claim on the
assets of a firm. There may be priorities of claims, such as junior
and senior or subordinated and unsubordinated. zMortgage bonds are
secured bonds, which have the first claim on a specific asset.
zIncome bonds arise out of bankruptcies. Important Terms
Slide 16
10-16 zBecause there are so many corporate bonds outstanding
and each issue has special characteristics, rating agencies have
developed to provide information to investors about to the
likelihood of default. zThe three largest rating agencies are
Moodys, Standard & Poors, and Fitch. Bond Ratings
10-18 Bond Ratings Ba1BB+Likely to fulfill Ba2BBobligations;
ongoing Ba3BB-Uncertainty B1B+ B2BHigh Risk Obligations B3B-
CCC+Current vulnerability CaaCCCto default CCC- CaCCIn bankruptcy
or CCdefault or other DDmarked shortcomings
Slide 19
10-19 Treasury Spread Bond Yield Yield on Comparable Maturity
Treasury Security (Default-Free) = . Treasury Spread Bond Rating 4%
2% 1% AAAAAABBBBBB 3%
Slide 20
10-20 Underwriter Spread Bond Rating 4% 2%.75% AAAAAABBBBBB
3%
Slide 21
10-21 Factors Determining Bond Ratings zWhile the rating
agencies do not follow a simple formula in determining ratings, the
following factors have been found to be statistically important
determinants of ratings.
Slide 22
10-22 zA bond will tend to have a higher rating if the
following are true: yThe firm has lower debt ratios (debt/assets,
debt/equity). yThe firm has higher interest coverage ratios
(earnings before interest and taxes divided by interest). yThe firm
has higher rates of return of assets (profit/assets,
profit/equity). yThe firm has lower relative variation in earnings
over time. yThe firm is of larger size. yThe bond issue is
unsubordinated.