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Default Risk Slide Premium by MikeJenny

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Default Risk Slide Premium

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									05 – Default Risk
Junk Bonds
   Fallen Angels – bonds that were initially
    issued as investment grade that were
    subsequently diminished to junk

   Original Issue Junk: bonds issued with low
    credit rating
     Lower  on the priority scale of firm payments
      than “senior debt”
Default-Free Bond Example
   Face value = 1000
   Price=900
   YTM: 1000/900-1 = 11.11%
   Matures in 1 year

   Bond has no chance of default. Guaranteed to
    get $1000 at maturity.
   If you hold the bond to maturity, you earn
    11.11% return.
    Defaultable Bond
   Zero-coupon defaultable bond:
     Face value: 1000
     Matures in 1 year
     Price=$800
     YTM: 1000/800-1=25%
     May default
           Suppose investors expect to get only $920 back
     Expected      YTM = 920/800-1=15%
    Default Risk Premium
   Default risk premium (DRP) =
(YTM defaultable bond)-(YTM default free bond)

    In example
    -   DRP=25.00%-11.11%=13.89%


   Why is the yield on low-grade bonds higher than
    that on default-free bonds?
   That is, why is the price of the junk bond lower
    than of the default-free bond?
Default Risk Premium
   Prices for low grade bonds are low, in part,
    because investors don’t expect to get all
    promised payments.
     Default-Free Bond        Defaultable Bond
             1000                   1000

            11.11%                   25%
                                      920
             900                             Investors expect to get
                                       15%   only 920 in payments.
                                             They expect to earn a yield
          YTM is always calculated    800    of 15%
          using promised payments.
    Expected Yield
   YTM: calculated using promised payments.
   Expected YTM: calculated using expected
    payments.

   In example, if YTM of the junk bond was 11.11%,
    price would be 900 and investors would expect to get
    a yield of only 920/900-1=2.22%

   Any reasonable investor should not hold low-grade
    bonds unless the expected yield is at least as high
    as that on default-free bonds.
Expected Yield
   Why is expected yield on low-grade bonds
    higher than on default-free bonds?
That is, why isn’t the price of the low-grade bond 828.08?

     Default-Free Bond     Defaultable Bond
             1000                1000

            11.11%       YTM 20.8%
                                         Why isn’t the price of the low
                                   920   grade bond 828.08? At this
             900                         price, the expected yield from
                                  11.11% the low-grade bond is the
                                         same as on the default-free
                                 828.08 bond.
    Expected Yield
   Why is expected YTM on junk bonds higher?

   Because of the uncertainty regarding
    promised payments.
     In example, the 920 expected payment is only a
      guess. In reality, the firm could end up paying a
      lot more or a lot less.
    Expected Yield
   In general, riskier financial assets are priced
    so that, on average they are expected to give
    higher returns.
     Small   Stock vs. Large Stocks


   Any kind of uncertainty that causes returns,
    on average, to be higher is called systematic
    risk.
Default Risk
   Systematic Default Risk: The uncertainty
    surrounding payments investors will
    actually receive on a low-grade bond.

   Because of systematic default risk, the
    expected (average) yield on low grade
    bonds is higher than the yield on default-
    free bonds.
    Systematic Default Risk Premium
   Systematic Default risk premium =
    (Expected YTM defaultable bond)-(YTM default free bond)


   In example, SDRP=15.00%-11.11% = 3.89%

   This spread is determined by
       The level of uncertainty
       How investors feel about this uncertainty
Systematic Default Risk Premium

   Comparing across bonds, as uncertainty
    surrounding the expected payments
    increases SDRP increases.

   Across time, as investors feel “more
    queasy” about bearing this risk, SDRP
    increases for all bonds.
Bond Yields
 Yields and Financial Crises
   The default risk premium increases substantially during
    times of financial crises. Why?

1) Greater probability of default
    Investors expect to get less, and accordingly, prices drop.

2) There is greater uncertainty surrounding the expected
    payments.
    The systematic default risk premium increases leading to further
    drop in price and an even greater default risk premium.

3) Flight to quality
    During crises, investors flee to the safety of default free bonds,
    causing the yields of such bonds to decrease leading to an even
    greater default risk premium.
Yields and Financial Crises
   Illustration of points 1, 2, and 3 from
    previous slide

      Default-Free Bond   Defaultable Bond
              1000              1000

             11.11%            25%
                                 920
              900
                                  15%
DRP=25-11.11=13.89               800
 Yields and Financial Crises
    Illustration of points 1, 2, and 3 from
     previous slide

        Default-Free Bond   Defaultable Bond
Relative risk   1000              1000
of default free                            Expected payment drops
bonds drops.      8.7%                     due to higher probability of
Demand curve                               default (point 1)
                  920          37%
Shifts right.
Yields decrease                            Systematic default risk
                                     850
(point 3)                                  premium increases due
                                  16.4%    to greater uncertainty
     DRP=37-8.7=28.3                       (point 2)
                                     730
Source: Altman, “Defaulted Bond and Bank Loan Markets and Outlook” (2004)
Example
 YTM on default-free bond: 8%
 YTM on junk bond: 33.33%
 Expected YTM on junk bond: 12%


   Assuming these are both zero-coupon
    bonds that mature in 1 year, what is
    expected payment on junk?
Example
.333=1000/price-1
Price=1000/1.333=750
E[payment]/750-1=0.12
E[payment]=750*1.12=840

Suppose financial distress strikes and the market
  expects the junk bond to pay only 600 at year-
  end. Accordingly, the price drops to 530.

What is YTM? What is E[YTM]?
Example
   YTM of junk bond is 1000/530-1=87%
   Expected YTM = 600/530-1=13.21%

   What is the default risk premium before and after
    the financial crisis hit? Assume the crises
    caused the YTM of the default-free bond to fall
    to 7%.
     Before:  33.33% - 8.00% = 25.33
     After: 87%-7% = 80%
Example
   What is the difference in expected yields
    before and after the crisis? Assume the
    crises caused the YTM of the default-free
    bond to fall to 7%.
     Before:  12%-8%=4%
     After: 13.21%-7%=5.21%

								
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