industry is more adversely impacted by a recession than other industries such as consumer staples.
Micro Fundamentals
At the micro level, the analysis of a potential change in the credit spread focuses on the fundamental factors that may alter the individual corpo- ration’s ability to meet its debt obligations. These are the same factors that the rating agencies use to assess the credit default risk of a corpora- tion that we discussed earlier in this chapter.
EXHIBIT 2.7 Hypothetical 1-Year Rating Migration Table
Rating Migration (Transition) Table
The rating agencies periodically publish, in the form of a table, informa- tion about how issues that they have rated change over time. This table is called a rating migration table or rating transition table. The table is useful for investors to assess potential downgrades and upgrades. A rat- ing migration table is available for different lengths of time. Exhibit 2.7 shows a hypothetical rating migration table for a 1-year period. The first column shows the ratings at the start of the year and the first row shows the ratings at the end of the year.
Let’s interpret one of the numbers. Look at the cell where the rating at the beginning of the year is AA and the rating at the end of the year is AA. This cell represents the percentage of issues rated AA at the begin- ning of the year that did not change their rating over the year. That is, there were no downgrades or upgrades. As can be seen, 92.75% of the issues rated AA at the start of the year were rated AA at the end of the year. Now look at the cell where the rating at the beginning of the year is AA and at the end of the year is A. This shows the percentage of issues rated AA at the beginning of the year that were downgraded to A by the end of the year. In our hypothetical 1-year rating migration table, this percentage is 5.07%. One can view this figure as a probability. It is the probability that an issue rated AA will be downgraded to A by the end of the year.
A rating migration table also shows the potential for upgrades.
Again, using Exhibit 2.7 look at the row that shows issues rated AA at the beginning of the year. Looking at the cell shown in the column AAA rating at the end of the year, there is the figure 1.60%. This figure repre- sents the percentage of issues rated AA at the beginning of the year that were upgraded to AAA by the end of the year.
Rating at Start of
Year
Rating at End of Year
AAA AA A BBB BB B CCC D Total
AAA 93.20 6.00 0.60 0.12 0.08 0.00 0.00 0.00 100 AA 1.60 92.75 5.07 0.36 0.11 0.07 0.03 0.01 100 A 0.18 2.65 91.91 4.80 0.37 0.02 0.02 0.05 100 BBB 0.04 0.30 5.20 87.70 5.70 0.70 0.16 0.20 100 BB 0.03 0.11 0.61 6.80 81.65 7.10 2.60 1.10 100 B 0.01 0.09 0.55 0.88 7.90 75.67 8.70 6.20 100 CCC 0.00 0.01 0.31 0.84 2.30 8.10 62.54 25.90 100
In general, the following hold for actual rating migration tables.
First, the probability of a downgrade is much higher than for an upgrade for investment-grade bonds. Second, the longer the migration period, the lower the probability that an issuer will retain its original rating. That is, a 1-year rating migration table will have a lower proba- bility of a downgrade for a particular rating than a 5-year rating migra- tion table for that same rating.
Credit Watch
A rating agency may announce in advance that it is reviewing a particu- lar credit rating, and may go further and state that the review is a pre- cursor to a possible downgrade or upgrade. This announcement is referred to as putting the issue under credit watch. The outcome of a credit watch is in most cases likely to be a rating downgrade, however the review may reaffirm the current rating or possibly upgrade it.
During the credit watch phase the rating agency will advise inves- tors to use the current rating with caution. When a rating agency announces that an issue is under credit watch, the price of the bonds will fall in the market as investors look to sell out of their holdings. This upward movement in yield will be more pronounced if an actual down- grade results. For example in October 1992 the government of Canada was placed under credit watch and subsequently lost its AAA credit rat- ing. As a result there was an immediate and sharp sell-off in Canadian government eurobonds before the rating agencies had announced the actual results of their credit review.
Event Risk
Occasionally the ability of an issuer to make interest and principal pay- ments changes seriously and unexpectedly because of an unforeseen event. This can include any number of idiosyncratic events that are spe- cific to the corporation or to an industry, including a natural or industrial accident, a regulatory change, a takeover or corporate restructuring or even corporate fraud. This risk is referred to generically as event risk and will result in a downgrading of the issuer by the rating agencies. Because the price of the entity’s securities will typically change dramatically or jump in price, this risk is sometimes referred to as jump risk.
Here are two actual examples of event risk. The first is the takeover in 1988 of RJR Nabisco for $25 billion through a leveraged buyout (LBO).
The new company took on a substantial amount of debt to finance the acquisition of the firm. In the case of RJR Nabisco, the debt and equity after the LBO were $29.9 and $1.2 billion, respectively. Because of the need to service a larger amount of debt, the company’s rating was downgraded.
RJR Nabisco’s credit rating as assigned by Moody’s dropped from A1 to B3. As a result, investors demanded a higher credit spread because of this new capital structure with a greater proportion of debt. The yield spread to a benchmark Treasury rate increased from about 100 bps to 350 bps.
A security example of event risk is the rapid decline of WorldCom cor- porate bonds in 2002. At the beginning of 2002, WorldCom enjoyed a tri- ple A rating. Its 8.25% bonds due in 2031 were trading above par value at 106.68 in January of 2002. However, as rumors of WorldCom failing to meet its profit projections in 2002 began to swirl in February and March, WorldCom bonds began to drift downwards in value—trading at about 80 cents on the dollar by the beginning of April 2002. Then the bottom fell out. By mid-April, allegation of accounting “irregularities” were confirmed, and WorldCom bonds fell precipitously. Over a 2-week time period, World- Com bonds declined from a price of about 75 in mid-April to a price of about 42 by the end of April 2002. At the same time the rating agencies rapidly slashed WorldCom’s credit rating to junk status. Still, the worst was yet to come. By June, the total amount of the accounting fraud was con- firmed in the range of $10 billion, and WorldCom declared bankruptcy. Its bonds took another leg down in June of 2002 from a price of 45 down to 11. In the space of only six months, WorldCom went from a strong invest- ment grade “Buy” to a distressed debt “Sell.”
CHAPTER 3
47
Credit Default Swaps
y far, the most popular type of credit derivative is the credit default swap. Not only is this form of credit derivative the most commonly used standalone product employed by asset managers and traders, but it is also used extensively in structured credit products such as synthetic collateralized debt obligations and credit-linked notes.
A credit default swap is probably the simplest form of credit risk transference among all credit derivatives. Credit default swaps are used to shift credit exposure to a credit protection seller. They are similar to a credit default option discussed in Chapter 11 in that their primary purpose is to hedge the credit exposure to a reference obligation or issuer. In this sense, credit default swaps operate much like a standby letter of credit.
Our focus in this chapter is on the features, investment characteris- tics, and primary applications of credit default swaps. How they are used in structured credit products and how they are priced are covered in later chapters.