Determinants of Bond Safety

Bond rating agencies base their quality ratings largely on an analysis of the level and trend of some of the issuer's financial ratios. The key ratios used to evaluate safety are:

1. Coverage ratios—Ratios of company earnings to fixed costs. For example, the times-interest-earned ratio is the ratio of earnings before interest payments and taxes to interest obligations. The fixed-charge coverage ratio adds lease payments and sinking fund payments to interest obligations to arrive at the ratio of earnings to all fixed cash obligations (sinking funds are described below). Low or falling coverage ratios signal possible cash flow difficulties.

2. Leverage ratio—Debt-to-equity ratio. A too-high leverage ratio indicates excessive indebtedness, signaling the possibility the firm will be unable to earn enough to satisfy the obligations on its bonds.

3. Liquidity ratios—The two common liquidity ratios are the current ratio (current assets/current liabilities) and the quick ratio (current assets excluding inventories/current liabilities). These ratios measure the firm's ability to pay bills coming due with cash currently being collected.

4. Profitability ratios—Measures of rates of return on assets or equity. Profitability ratios are indicators of a firm's overall financial health. The return on assets (earnings before interest and taxes divided by total assets) is the most popular of these measures. Firms with higher return on assets should be better able to raise money in security markets because they offer prospects for better returns on the firm's investments.

5. Cash flow-to-debt ratio—This is the ratio of total cash flow to outstanding debt.

Standard & Poor's periodically computes median values of selected ratios for firms in several rating classes, which we present in Table 14.3. Of course, ratios must be evaluated

CHAPTER 14 Bond Prices and Yields 437

Table 14.3 Financial Ratios by Rating Class

CHAPTER 14 Bond Prices and Yields 437

Table 14.3 Financial Ratios by Rating Class

U.S. Industrial Long-Term Debt, Three-Year (1997 to 1999) Medians

AAA

AA

A

BBB

BB

B

EBIT interest coverage ratio

17.5

10.8

6.8

3.9

2.3

1.0

EBITDA interest coverage ratio

21.8

14.6

9.6

6.1

3.8

2.0

Funds flow/total debt (%)

105.8

55.8

46.1

30.5

19.2

9.4

Free operating cash flow/total debt (%)

55.4

24.6

15.6

6.6

1.9

(4.6)

Return on capital (%)

28.2

22.9

19.9

14.0

11.7

7.2

Operating income/sales (%)

29.2

21.3

18.3

15.3

15.4

11.2

Long-term debt/capital (incl. STD) (%)

15.2

26.4

32.5

41.0

55.8

70.7

Total debt/capital (incl. STD) (%)

26.9

35.6

40.1

47.4

61.3

74.6

EBIT—Earnings before interest and taxes.

EBITDA—Earnings before interest, taxes, depreciation, and amortization. STD—Short-term debt.

Source: www.standardandpoors.com/ResourceCenter/CorporateFinance, December 2000.

EBIT—Earnings before interest and taxes.

EBITDA—Earnings before interest, taxes, depreciation, and amortization. STD—Short-term debt.

Source: www.standardandpoors.com/ResourceCenter/CorporateFinance, December 2000.

in the context of industry standards, and analysts differ in the weights they place on particular ratios. Nevertheless, Table 14.3 demonstrates the tendency of ratios to improve along with the firm's rating class.

In fact, the heavy dependence of bond ratings on publicly available financial data is evidence of an interesting phenomenon. You might think that an increase or decrease in bond rating would cause substantial bond price gains or losses, but this is not always the case. Weinstein8 found that bond prices move in anticipation of rating changes, which is evidence that investors themselves track the financial status of bond issuers. This is consistent with an efficient market. Rating changes actually largely confirm a change in status that has been reflected in security prices already. Holthausen and Leftwich,9 however, found that bond rating downgrades (but not upgrades) are associated with abnormal returns in the stock of the affected company.

Many studies have tested whether financial ratios can in fact be used to predict default risk. One of the best-known series of tests was conducted by Edward Altman, who used discriminant analysis to predict bankruptcy. With this technique a firm is assigned a score based on its financial characteristics. If its score exceeds a cut-off value, the firm is deemed creditworthy. A score below the cut-off value indicates significant bankruptcy risk in the near future.

To illustrate the technique, suppose that we were to collect data on the return on equity (ROE) and coverage ratios of a sample of firms, and then keep records of any corporate bankruptcies. In Figure 14.9 we plot the ROE and coverage ratios for each firm using X for firms that eventually went bankrupt and O for those that remained solvent. Clearly, the X and O firms show different patterns of data, with the solvent firms typically showing higher values for the two ratios.

The discriminant analysis determines the equation of the line that best separates the X and O observations. Suppose that the equation of the line is .75 = .9 X ROE + .4 X Coverage. Each firm is assigned a "Z-score" equal to .9 X ROE + .4 X Coverage using the firm's ROE and coverage ratios. If the Z-score exceeds .75, the firm plots above the line and is considered a safe bet; Z-scores below .75 foretell financial difficulty.

8 Mark I. Weinstein, "The Effect of a Rating Change Announcement on Bond Price," Journal of Financial Economics, December 1977.

9 Robert W. Holthausen and Richard E. Leftwich, "The Effect of Bond Rating Changes on Common Stock Prices," Journal of Financial Economics 17 (September 1986).

PART IV Fixed-Income Securities

Figure 14.9 Discriminant analysis.

Figure 14.9 Discriminant analysis.

Altman10 found the following equation to best separate failing and nonfailing firms:

EBIT

Sales

Total assets Assets

1 4 Retained earnings i

Market value of equity where EBIT

Total assets earnings before interest and taxes.

Book value of debt Working capital Total assets

CONCEPT CHECK ^ QUESTION 8

Suppose we add a new variable equal to current liabilities/current assets to Altman's equation. Would you expect this variable to receive a positive or negative coefficient?

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