CREDIT RISK PREMIUMS

Transcription

1 CREDIT RISK PREMIUMS James A. Gentry Professor Emeritus of Finance and University Distinguished Teacher Scholar University of Illinois Frank K. Reilly Bernard J. Hank Professor of Finance University of Notre Dame David J. Wright Professor of Finance University of Wisconsin-Parkside February 19, 2009

2 2 CREDIT RISK PREMIUMS Bond investors expect to receive a premium for taking credit risk when investing in investment grade or non-investment grade bonds. This risk premium is referred to as either a credit risk premium (CRP) or a credit risk spread (CRS). Changes in the outlook for a company can result in changes the CRP. For example, an increase in the CRP of a company sends a negative market signal to investors, corporate management, bond traders, bank loan committees and other interested stakeholders. Required credit risk premiums are to the bond investors what required equity risk premiums are to common stock investors. Credit risk premiums represent the spread that exists between the yield-tomaturity [YTM] on corporate bonds and the YTM on 10 or 20 year U. S. Treasury (UST) bonds. For example, the spread between YTM on a BBB rated corporate bond and the YTM on risk-free long-term UST bonds reflects the credit risk premium (CRP) or credit risk spread (SRS) received by BBB corporate bond investors. In equation form, CRP or CRS = K BBB K RF K BBB = current market rate of return (YTM) on an S&P rated bond. K RF = YTM on a risk free long-term UST bond We shall use Figure A to develop the components that underlie the theoretical structure of rates of return on UST bonds and corporate bonds. In creating this example we shall start by assuming the pure rate of return is 3 percent. The pure rate of return is assumed to be the return generated on any asset regardless of s firm s capital structure, e. g., its debt ratio, or the credit risk of the firm that is reflected in its bond rating. The pure rate is the base rate or the minimum return expected on an asset.

3 3 What would be the next theoretical concept used in explaining the structure of interest rates of return? The next level reflects the rate of inflation. Let s assume the rate of inflation is 4 percent. Will inflation be constant across all capital structures, regardless of the firm s bond rating? Yes, inflation is assumed to be constant in the economy across all capital structures and/or bond ratings. Thus, the risk-free rate of return on a 20 year UST bond (K RF ) is 7 percent, i.e., K RF = The final component in the structure of interest rates reflects the creditworthiness of a company, referred to as firm s credit risk exposure. What is the creditworthiness of the UST bonds? The assumption is that the U. S. Treasury bonds are risk-free, and investors do not expect to receive a credit risk premium on UST securities. How does the bond market determine the credit risk premium on a corporate bond? Determining the creditworthiness of a company is a complex process. Figure A simplifies this process by assuming a firm s creditworthiness is reflected in its debt ratio. For example, if a company has a low debt ratio, say a D/D+E ratio of 20 percent, it would more-than-likely receive a Moody s bond rating of Aa. Under these conditions bond investors would expect to receive a low credit risk premium, for example 50 basis points greater-than the risk free rate of 7 percent or return of 7.50 percent, K daa = If a company has a debt ratio of 30 percent, it is apparent that its credit risk is greater than the preceding example. Under these conditions bond investors would expect a higher credit risk premium, for example 125 basis points greater than the risk free rate, or a return of 8.25 percent. If a third company has a debt ratio of 50 percent, the credit risk premium is going to be significantly higher, say 300 basis points or 10 percent.

4 4 Thus, the higher the perceived credit risk, the lower a firm s creditworthiness and, in turn, the greater the credit risk premium. Size and Stability of Credit Risk Premiums In a recent working paper The Historic Changes In the High Yield Bond Market, Reilly, Wright and Gentry (RWG) [2009] reached several significant conclusions. First, they observed the overall high yield (HY) bond market has experienced strong cyclical growth, over 13 percent a year for 20 years, there has been a significant change in its composition with the strongest growth recorded in the BB-rated segment 1. Second, RWG noted an analysis of return volatility indicated tat during periods of economic stability HY bonds experienced volatility very similar to investmentgrade bonds, but HY bond volatility become about three times greater during periods of economic uncertainty. 2 The following provides a brief analysis of the size and stability of CRS for the 20 year period, , Exhibits 1-4 show the CRS for AAA, AA, A and BBB rated bonds, respectively. The CRS for the HY bonds rated BB, B and CCC are presented in Exhibits 5-7, respectively. The size and stability of the CRS are shown in Exhibit 8 for all seven bond ratings in five sample time periods. The size of the CRS is measured in basis points (bp) and the stability is reflected in the volatility of the CRS. 1. Reilly, Wright and Gentry, 2009, Historic Changes in the High Yield Bond Market, Working Paper, p Ibid.

5 5 January 1989 reflects the end of a relatively stable period of business conditions and the beginning of a period unstable business conditions. Exhibit 8 shows the CRS were relatively low for the investment grade bonds-50 to 125 bp, but high for the HY bonds, 270bp to 700bp, thereby suggesting the beginning of a period of economic uncertainty. In January 1993, Exhibit 8 reflects the ending of a period of economic uncertainty. The CRS ranged from 150 to 200 basis points for the investment grade bonds, and these CRS are substantively higher than the basis points in January However, The CRS for the HY bonds were only modestly higher than the CRS for investment grade bonds on January 1993, 240 bp to310 bp. The pattern of the CRS on January 1998 portrays a CRS pattern that is comparable to the January 1989 period, as shown in Exhibit 8. The CRS for the investment grade bonds were relatively small, 75 bp to 110 bp, and the HY CRS ranged from 280 bp to 800 bp. The CRSs for the January 2004 also looks like the end of an unstable period. The CRS for the investment grade bonds range from 40 to 180 bp, and the AA rated bonds had a lower CRS than the AAA rated bonds. The HY bond CRSs ranged from 200 bp to 500 bp In December 2008 the CRS are at an all time high for both the investment grade bonds and the HY (junk) bonds. If the risk-free interest rate was 2 percent the BBB rated bonds had a bond yield of 9.2 percent and the CCC rated bonds reflected a bond yield of 29 percent. A phenomenal set of CRS appear in Exhibit 8. The size of the CRS indicates periods of great uncertainty in future economic conditions.

6 Figure A Credit Risk Premium Interest (%) Valueof Value of Debt V = Firm V d = F Debt Ratio (In percent)

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11 EXHIBIT 5 - High Yield BB-Rated Bond Credit Spreads (Barclays Capital BB- Rated Corporate High Yield Bond Index Yield Minus the Ten-Year Treasury Yield) with Spread Mean, and Plus and Minus Two Standard Deviations Jan Dec BB-HY Credit Spread Mean (332 bp) Mean + 1*Std. Dev. (471 bp) Mean + 2*Std. Dev (610 bp). Median. = 312 Std. Dev. = 139 Mean - 1*Std. Dev.(193 bp) Mean - 2*Std. Dev.(54 bp) BB Rated Credit Spreads in Basis Po oints Month-Year

12 EXHIBIT 6 - High Yield B-Rated Bond Credit Spreads (Barclays Capital B-Rated Corporate High Yield Bond Index Yield Minus the Ten-Year Treasury Yield) with Spread Mean, and Plus and Minus Two Standard Deviations Jan Dec B-HY Credit Spread Mean (523 bp) Mean + 1*Std. Dev. (733 bp) Mean + 2*Std. Dev (943 bp). Median. = 472 Std. Dev. = 210 Mean - 1*Std. Dev.(312 bp) Mean - 2*Std. Dev.(102 bp) B Rated Credit Spreads in Basis Po oints Month-Year

13 EXHIBIT 7 - High Yield CCC-Rated Bond Credit Spreads (Barclays Capital CCC- Rated Corporate High Yield Bond Index Yield Minus the Ten-Year Treasury Yield) with Spread Mean, and Plus and Minus Two Standard Deviations Jan Dec CCC-HY Credit Spread Mean (965 bp) Mean + 1*Std. Dev. (1,464 bp) Mean + 2*Std. Dev (1,963 bp). Median. = 763 Std. Dev. = 499 Mean - 1*Std. Dev.(465 bp) Mean - 2*Std. Dev.(-34 bp) 3000 CCC Rated Credit Spreads in Basis Poin nts Month-Year

14 EXHIBIT 8 CREDIT RISK SPREADS (Estimated basis Points (bp) AVOVE the YTM on a UST) =(in pb) AAA AA A BBB BB B CC Jan Jan Jan Jan Jan