 Hello and welcome to the session. This is Professor Farhad in which we would look at the fault risk and bond ratings. Those topics are covered on the CPA BEC section as well as the CFA exam. FarhadLectures.com is a website that's going to supplement your CPA preparation as well as your accounting and finance courses. Please check it out. LinkedIn is where you will need to connect with me if you haven't done so. YouTube please subscribe to my channel. I have 1800 plus accounting, auditing, finance, tax as well as Excel tutorial. If you like my lectures, please like them and share them. If they benefit you, it means they might benefit other people. Share the wealth. Connect with me on Instagram and Facebook and this is my website once again, farhadlectures.com to supplement your accounting and finance as well as CPA preparation. Let's talk about bonds and we can break the bonds into two categories. Think of grading. Think of when you take a class, you are giving a grade, either an A, A minus, B plus, C, whatever that grade is. Also, when you borrow money from the bank, each individual will be judged based on their credit score. And this is what we are talking about now. For example, as individual, the highest credit score is 850. So if you have an 8, you know, if you have an 840 credit score, I'm very proud of my credit score. My credit score is above 800. You will get the best interest rate available that the bank has to offer. Now, bonds go through the same grading procedures. But if you want to break the bond, the bond rating into two categories, and those will be investment grade and speculative or junk or high yield grade. So what is an investment grade bond? An investment grade bond is a bond rated AAA and above by SMP or BAA and above by Moody's. So who's SMP, Standard Importers and Moody's? Those are the rating agencies. Those are not the only one. Those are the biggest one, the most famous one. And what they do is they rate you. They rate your bond, whether it's, for example, SMP, they would use AAA. It has the highest quality. And basically, if you're AAA, it means that rated has the highest credit rating capacity to pay interest and principle extremely strong. It means if you buy this bond, there's practically no chance of not getting the money in the interest. That's what they're saying. It's very strong. Then you have AA. AA means has a very strong capacity to pay interest together with the highest rating. This group compromised the high grade bond class. So you want to be either AAA or AA or Moody's. They have A and capital and lower case two A's and upper case and lower case A's. Just the way they use the rating, but they're basically the same thing. Then you could be AA or BBB or B, which is considered high quality. Again, you could read about what does that mean when they say AAB? Well, is regarding as having adequate capacity to pay interest and repay the principle, whereas normally exhibit adequate protection parameters, adverse economic condition or changing circumstances are more likely to lead to a weakened capacity to pay interest. So simply put, if you are AAB, you're not as good as AAB is not as good as AAA. And if you have AAB, then you become what's called speculative or grade or junk bond. So you really want to be, if you want to be investment grade, you want to stay in these two categories. Now speculative grade or junk bond, a bond rated AA or lower by SMP is considered or lowered by Moody's. Those are considered speculative or junk bond. So here's speculative or junk bond. Now, why that's, why is that important? That is important because if you are speculative or a junk or junk bond or high yield bond, what's going to happen is the company that, that, that is rated that way, Durban's is rated that way, they have to pay higher interest cost. Because if you are going to be investing in those bonds, you need to be compensated. It means for the company that's a higher cost, that's more expenses, that's lower profit. Okay, but the investor, the lender, they want to be compensated for that risk. Now the speculative bond before 1997, all almost all bonds were falling angel. Falling angels mean to get to these junk status, you were before investment grade. Okay, bond issued by the firm had originally had an investment grade, then their situation deteriorated and they went from this category to this category. Okay, however, firms began to issue in 1977 original issue junk bond. Now starting in 1977, 1977, what happened is companies started to issue junk bond. Okay, so much of the, much of the credit of this innovation is giving to a firm called Drexel Berman Lambert and especially its trader, a guy named Michael Milken. And if you have time, I suggest you Google him, or YouTube him and to learn a little bit more about him. So firm not able to master an investment grade, we're happy to go to Drexel. And what they did is they raised money for them through those junk bonds. So right from the get go, your bond was speculative. Okay, so eventually what happened, high yield bond, they were very famous in the 1980s. And they were used to finance leverage buyout and hostile takeover between companies. But what happened eventually Drexel, the firm and Michael Milken, they get, they went into trouble. They get into trouble on Wall Street from an insider trading scandals. And the junk, the junk bond market was kind of, they were associated with that market. So when they went to jail, kind of lost a little bit of steam that it came back later. But I suggest, if you're interested in this, just YouTube or watch a documentary about this topic, it's very interesting and interesting personality Michael Milken. But it's beyond the scope of this recording, but you could check him out yourself. So how do, how do rating agencies determine whether a bond is a AAA, AA or triple C? Well, they look at, they look at certain financial indicators. What are those some of those financial indicators? Now we're going to look at few. It doesn't mean those are the only one, but those are important ones. First, they look at that with something called the coverage ratio. And we're going to learn about those later on. When we look at our financial statement analysis, we look at these ratios, but we're going to cover them briefly here. It's the ratio of companies earnings to fixed assets. So how much earnings do you have in comparison to your fixed asset, to your fixed cost? Usually what is your fixed cost? Like the main thing in your fixed cost is interest because interest is a fixed cost. So how much are you earning comparing to your fixed cost? One specific example will be something called the times interest earned. And basically what that is, they will take your interest, your income before interest and taxes. So they will take the ratio of your income, your earnings before interest and taxes. So E, B, I, T, your earnings, E for earnings. So your income before interest and taxes, and you'll divide this by your interest expense, by I. So let's assume you have earnings of $10 and your interest expense is two. It means we say your coverage is five. Now, if another company has an earning of 20 and interest of two, their coverage is 10. It means they can cover their interest expense 10 times. You can cover your interest expense five times. So obviously, the higher this ratio, the better off you are. Low or falling coverage ratio, signal possible cash flow difficulties. Now, that's not the only coverage ratio, but that's one of the most famous one, your earnings before interest and taxes. Also, they could look at something called the leverage ratio and there are a lot of leverage ratio, but we're going to be looking at debt to equity. Now, let's see what this is. A high leverage ratio indicate excessive indebtness, raising the possibility of the firm will enable to earn enough to satisfy its obligation. And this ratio is very easy to explain because as it treats, debt to equity. So take your debt. So if you have debt of 30 and you have equity of 10, which is, let's see, 30 divided by 10 is three. This is your debt to equity. What does that mean? If we have debt of 30 and equity of 10 as an accountant assets equal to your debt plus your equity, it means you have assets of $40, of which $30 coming from that and $10 coming from equity. It means you are highly leverage. So for every dollar, the investors bring in, you are using $3 from the lenders. Yeah, investors would love this. They're risking $1. The debt holders are risking $3. So if you have high debt to equity ratio, you are simply a risky company because what's happening is you are using the lenders money. So the shareholders, they're putting $1. You're bringing $3 from the bondholders or from the bank or from the lenders. It's a very risky endeavor. And think about it. If you are a stockholder, if you own this company, the maximum you would lose is $1. They would use $3. So you are highly leverage. You may take excessive risk. So it's a high risk endeavor. Another type of ratio, again, we'll talk about those ratios later on. This is just kind of to tell you what indicators they look at. They look at liquidity ratios. What is liquidity ratios? The two most common ones. It's the one that you learn first two ratios are the current ratio and it's cousin, the quick ratio. And basically what is the current ratio? Taking your current assets, dividing your current assets by your current liabilities. So if you have current assets of 20, current liabilities of 10, we say the ratio of two. It means for every dollar in current liabilities, you are covered $2 in current assets. Now you want this to be as high as possible, but you don't want it to be too high because you don't want your assets to be tied into current liabilities because current liabilities don't earn a lot. Like if you have cash in the bank, cash don't earn you a lot of money. The related or its cousin, the quick ratio, basically the quick ratio is taking your current assets, executing inventory and specifically not only executing inventory, you've had to exclude accounts like supplies, prepaid, small, small current assets. Basically what you keep is your cash. When it comes to the coverage, the quick ratio, you'd only use cash, investments, short-term investments and account receivable and you'll divide those by current liabilities. Basically, it's similar to this one except you will take the inventory out. Simply put, what you are saying is, let's assume my inventory is useless. Can I still pay off my liabilities? That's what you're saying. So obviously, always, always, always the quick ratio for any particular company is lower than the lower than the quick ratio is lower than the current ratio because remember what you're doing is you are removing from the $20, but you are not removing from the $10. So you are removing numbers from the numerator, which is current assets, but not from the denominator. Another, again, I'm going to say, I don't want to keep repeating this, but we'll talk about those later. Profitability ratios measures the rate of return on your assets or equity. So simply put, how much money are you earning in relationship to your assets? How much money are you earning in relationship to the equity to the shareholders? The profitability ratio is an indicator of the company's overall performance. Of course, you want the profitability ratio to be high. You want to be making a profit to be a good company. If you're making a profit, guess what? Then you can pay off your debt. If you can pay off your debt, we're going to give you a good credit rating. Just like if you have a job, you're paying off your debt, you're going to have a better credit score. So return on asset, which is earnings before interest and taxes divided by total asset and we'll explain later why it's earning before interest and taxes and return on equity. Same thing, you'll take in that income dividing by equity. Those are two, the two most popular measures. There are other profitability ratios, but those are the two most popular measure terms with higher return on asset or equity should be able to better raise money in security market before they, before the offer prospect for better return on the firm investment. Of course, if you are making a profit, you want to borrow money, you are less risky because you are making profit. The lenders are not worried about your credit risk. So they are willing to lend you the money and they're willing to lend you the money at a lower, at a lower interest cost and cash flow to that ratio. I believe that's the most accurate or the best one to cover to not to cover to look at is looking at your cash flow to that. So tell me how much cash do you have to cover your debt? I mean, all the others are good, but at the end of the day, you pay your debt with cash. So what is your cash flow in relationship to your debt ratios? I want to see that. So those are five important indicators and here they, you know, here, for example, you can, you can see them side by side. For example, here, they're, they're, they're looking at earning before interest and taxes divided by total assets and for a triple A company, it's 20.9. For example, for double A company, it's 15.6. So you want this ratio to be high here, the profitability notice the triple A, they have, they have good asset coverage. They have good, good profit margin ratio. They have a good interest coverage multiple EBIT to interest coverage debt to earnings before interest and taxes multiple. They're all high debt to debt to equity. You don't want it to be high. So this is low, which is good. You want it to be low. The others high funds from operation to total that. So this is high as well. So notice retained cash flow in relationship to your to your debt. This is high. So notice if you compare those triple A figures for these ratios to these, as your financial situation deteriorated, guess what? Then your credit rating will go down. For example, if you're operating margin, operating profit margin, you're only making 8.9. Well, you're not going to be graded as triple A because the triple A company is making profit for every dollar in sales. They're making 22% in profit here. Triple A, their debt to equity is only 19% here. Your debt to equity is 72. And here for C, practically dollar for a dollar, for every dollar in debt, for every dollar in equity, you have a dollar in debt. So this is how, in other words, this is how or this is what those S&P and Moody's look at when they evaluate the credit ratings of the companies. They look at ratios like these. Let's look at more terms that deals with bonds and credit rating. One of them is indenture. And basically, what is an indenture? Simply put, it's a contract between the bondholder and the issuer. Why? Because if something happens, you need to spell out, we need to find out who's going to be paid first and how and if there's any collateral. So the bond indenture, it will spell out, it will spell out the specific conditions between the bondholder and the lender because things will happen. And sometime you'd have two bondholders. Who's going to get their money first? Well, we're going to deal with that shortly. But this is why you have to spell out what are the, what is the contract? What does the contract says? We have something called the sinking fund. It's a bond indenture that calls for the issuer to periodically repurchase some proportion of the outstanding bonds prior to maturity. And basically, a bond indenture, basically it's a contract, the sinking fund, it's part of the indenture. It basically, what it's saying, it's saying, look, don't wait until all the bonds mature all at once. You might have to come up with a lot of money. Why don't you create a sinking fund? What is a sinking fund? Put some money away in a fund, let it sink. In other words, put it away from everything else and start to buy those bonds periodically. So the firm will, will, may repurchase a fraction of the outstanding bonds in the open market each year. Why? So they don't have to pay all the bonds all at once when they come mature. So the firm have the option to purchase the bonds at either at the market price or sometimes they have a sinking fund price. If there is a sinking fund price, obviously you will buy it based on the lower of the two. So to allocate the burden of the sinking fund called fairly among bondholder, the, the bonds chosen for the court are selected at random based on serial number. So because which bond are you buying? Well, you would randomly select them because think about it. Some people want, you know, to redeem their bonds. So they'll be happy to give you back the bond and give them back their money. But the sinking fund bond differ from, you remember we talked about the callable bond, differ between, between the callable bond in two different ways. The firm can repurchase only a fraction of the bond, not everything. Sometime they allow them to double in some contract, they would say we might be able to buy 10% and under certain circumstances by 20% of the bond. That's first thing. So you cannot buy everything. Also, callable bond, when you have a callable bond, the callable bond has a premium cost. In other words, the company will pay more than the par value for the bondholder. The sinking fund bond, usually they're set at par value. They're going to give you exactly what the par value is. Let's take a look at additional terms that are relevant to bond rating, a subordinated or further debt. What does that mean? Now think about it. One of the factors that determine the credit riskiness of the company is how much debt you have because the more debt you have, the worse off you are, if you think about it. Now what's going to happen is to prevent firms from harming bondholders, subordination clauses to restrict the amount of their additional borrowing. So they would say, okay, if you want to borrow more, they would say, okay, you can borrow more. But if in case anything happened, we are paid first. Okay. So additional debt might be subordinated in priority to existing that. So they would say, okay, if you want to borrow, I would let you borrow. They will put that in the indenture, but if something happened, we get paid first. So in the event of a bankruptcy, subordinated or junior debt holder will not be paid unless the senior debt holder is paid in fold. And this makes sense. I want to protect myself. I gave you the money first. Therefore, I have a priority in case something happened. Also, bondholder to protect themselves, they might put what's called dividend restriction in the covenant. Okay. So those are covenant, limiting dividend, protect bondholder because they forced the firm to retain assets rather than pay them out to stockholders. Now think about it. Think about it from the stockholders perspective. The stockholders, they want you to pay every single penny out and profit in dividend because that's their company. The bondholders on the contrary, they don't want you to pay anything out in dividend because they want to keep the money. So you pay, you pay back the interest plus, plus the bond, you pay back the interest plus the bond. So a typical restriction with this allow bond payment of dividend if cumulative dividend paid since the firm inception exceeds cumulative retained earning plus the proceeds of the sales of the stocks. So they will put something like this. And this is just an example of a restriction. Well, once you paid, once you have paid dividend equal to the profit, you know, it equal to the cumulative retained earning, which is the cumulative, the cumulative profit over the years, plus the sale of the stocks simply put once you distributed all your profit and you distributed enough dividend to cover the sale of the stock. We don't want you to pay dividend anymore. Also, a bondholder might have might request collateral. So some bonds are issued with specific collateral behind them. For example, well, in case you could not pay me, you have to sell your building or you have to sell your warehouse or you have to sell part of your inventory. That is a collateral. It's a particular asset that's pledged against that bond. And obviously, if you have a collateral as a bondholder, you are better off because if something happened, you will be paid. Okay? Sometimes they're called mortgage bond, collateral or mortgage bond in contrast to the venture. What are the venture? Guess what? You're really in big trouble when you have an adventure as a bondholder because you are not backed by any specific collateral. So when you give them the money and they say this is a venture bond, guess what? It means you have no protection whatsoever. So good luck if something happened. You have no assets to back up to to to back up the bond. Let's talk about yield to maturity and the fault risk. So obviously, the fault risk means what? You know, corporation might be subject to the fault. It means at some point, they may not pay you the money. So we must distinguish. So when you buy a bond between the bond promised yield to maturity, and it's expected yield, those are two different things yield to maturity and expected and expected yield. The promise or the stated yield will be realized. Simply put, if they're promising 8%, well, you're going to earn 8% if the firm meet the obligation of the bond. Simply put, if they promise you 8%, that's the maximum you will earn if they pay you the bond because this is how much you earn. Now, this is the promise or the stated yield, which is technically is based on the coupon. The expected yield to maturity, this is expected. Notice, this is what you are promised based on the stated yield. This is the expected. The expected is must take into account the possibility of a default. What does that mean? It means, well, guess what? You may not get your money at the end of the day. So what is your yield? What's your expected yield under those circumstances? Let's work an example to show you how this worked. So for example, at the height of the financial crisis in October 2008, I still remember that very vividly here. Ford Motor Company struggled and it's 6.625 coupon. So they have a coupon and it's being 6.625. Okay. And it's due in 2028 and they were rated triple C, which is a very low credit rating. And they were selling about 33% of par value. It means they were selling at a discount. And if you bought those bond, if you bought those bond at 33% discount of their value, you would have your yield to maturity, which is 20%. This is excellent. Here's the trick. When the yield is too high, why is the yield too high? The yield is too high because the bond is discounted. So they're paying 6.625. That's a high coupon. It's not only a high coupon. The bond went down in price. The bond went down in price. Therefore, you would earn 20%. But the problem with these bonds is what a Ford Motor Company is not an existence in 2028 when they become due. Now, luckily, Ford did survive. And the reason why Ford survived, that's a different story because right before the financial crisis, not because the CEO was smart, just they happened to have to refinance everything and they have cash on hand. Therefore, they survived the financial crisis in contrast to GM. But if you bought those bonds, well, although they promise 6.625, your actual, your expected would have been 20%, which is a great deal, a great deal. So bonds become more subject to the fault risk when the price is fault. So you have to be very careful when you're looking at a bond and the bond has a high yield. The reason why you would have a high yield is because there's a good chance that the bond is down in price. The reason it's down in price, because it's not credit worthy. So you have to be very careful with those bonds. So suppose a firm issued a 9% coupon bond for 20 years. And let's assume the bond had 10 years left until it matured. But the bond is having some financial difficulties. Well, near the investors believe that the firm will be able to make good on the remaining interest payment. But at maturity, it will be forced into bankruptcy and the bondholder would receive only 20%. So I'm sorry, not 20%, they would receive 70%. So the bond right now is selling at $750. So rather than 1000, basically it's discounted to $750. Now yield to maturity, that's going to change. That's going to change. So here's what's going to happen. It pays 9% coupon. It means $45 payment. The remaining life is 20 years and 20 years. The stated yield to maturity, we have to use $1,000 because that's what it's stated. And the price right now is $750. Now we have to compute i. So if we compute i, the stated yield to maturity, which is based on the promised payment, is $13.7. Based on the expected payment, which is here, expected YTM, only you would yield 11.6%. So the stated yield here is greater than the yield investors actually expect to earn. So if we look at the numbers, basically what you have to do, just go to the financial calculator and input the payment, PMT equal to 45, the number of payment and equal to 20. The final payment is the future value and the price is PV negative $750 and compute i and it's going to give you the yield. It's going to give you the yield. Suppose the condition of the firm deteriorate further and the investor now believes the company will pay only 55%. So simply put what you do as you take this price and now you're getting only $550, 55%. If we compute this, now the stated yield to maturity based on the promised cash payment is 15.2. While the expected yield to maturity increased by 0.04, the trap and price caused the promised yield and the default premium to rise by 1.5%. Very, very interesting. Let's take a look at the default premium. To compensate for the possibility of default, corporate bond must offer a default premium. And what is the default premium? That's the difference between the yield on the corporate bond and the yield of otherwise risk-free or identical government that's riskless in terms of default. So if I want to buy a corporate bond, well guess what? I want to make sure I'm going to be earning more than what I would pay for the U.S. Treasury or Treasury bond. Why? Because the Treasury bond has zero interest, it has zero credit risk. If I'm going to be buying your bond, I need to be compensated. That extra compensation is the default premium. In case something happened, I want to be compensated. So if the firm remains solvent and actually pay the investors all the promised cash, guess what? I'm going to get a higher return than if I put my money with the government because I am taking a higher risk. Well, if however the firm goes bankrupt, the corporate bond is likely to provide a lower return than the government. Simply put, you're going to lose your money and this is why you would get a lower return. So the corporate bond has the potential for both a better or worse performance than a default free Treasury bond. Of course, when you lend money, you are taking risk. It's not as risky as buying stocks, but it's riskier than the Treasury bond, the government giving your money to the government. So in other words, it's riskier. Of course, it is. Of course, it is. Uncle Sam is the safest. Well, we can say that so far. So hopefully, let's hope we will stay. It will stay that way. Otherwise, we'll have an arm again. We'll have a big problem. Who knows? So also, we have something called the risk structure of interest rate. It is the pattern of the fault premium offered on risky bond. This is called the risk structure of interest rate. And what happened is this, the greater the default risk, the higher the default premium. Of course, let's take a look at those different types of bond, high yield bond, triple B bond and triple A bond. So it notes the triple A bond, the yield from the 70s, it doesn't differ that. So they don't have to pay a lot of risk premium. Why? Because they're already notice, they're already close to zero. So they don't go that far. But if we're looking at the high yield bond, high yield bond, when the situation deteriorate, when the economic, when we have an economic problems to buy those bonds, you're going to have to pay, they're going to have to offer a premium for the investors to buy them. So notice the yield spread is very, very high. Why? Because they are riskier. They are riskier. Credit default swaps or CDS, those are a form of insurance policy on the default risk of a bond or a loan. So what you do is you buy them. So if you have a bond, you buy them, you'd say, okay, in case something happened to my bond, someone will pay me. So if you want to invest in AT&T bonds, and you invest in AT&T bond, and what you do at the same time, you buy insurance from someone else, from a bank, from an investment company, and they would agree, and you'll pay them a premium just like any insurance, we call credit default swap. And basically what happened is if AT&T don't pay you back the money, they will pay you back the money. So the annual premium, and you can buy this on bonds, government bond or sovereign bond, which is government or corporate. So the annual premium in early 2010 on a five years sovereign Greek bond was about 3%, meaning if you have a bond principle of $100, you have to pay $3. That's little bit expensive. So the CDS seller collect the annual payment for the term of the contract, but must compensate the buyer for the loss of the bond value in the event of a default. Now a lot of companies did not think they were taking a big risk when they sold those credit default swap into 2008 financial crisis because they never thought that those bonds would collapse, but those bonds eventually collapse. So CDC contract on corporate as well as they're available for sovereign debt. And back then, they did not have credit default swaps on mortgage backed securities. So if you watch the big short, or if you read the book, they went to the investment bank and they tried to convince them to write those credit default swaps. While CDC were conceived as a form of bond insurance, that's the original purpose of them. It wasn't long before investors realized they could use them as speculative. So simply put what you're doing is like you're buying fire insurance on your neighbor's house. That's basically what they are, because if something happened to your neighbor's house, if something happened to the bond, you will be paid. That's basically how it works. So if we look at John Paulson, who predicted the imminent financial crisis, purchased those CDS contract on mortgage bonds and actually they did not exist yet to convince investments, banks and banks to sell them those, as well as debt of financial firms that would have profit as their CDC prices spiked in September, right before the crisis. So his bearish bet because he knew those bonds gonna go bad made his firm 15 billion. He got 3.7 billion by doing this bet. This is, you know, again, watch the big short or read the book. In the next topic, we would look at yield curve. Again, I would like to invite you to like this recording, share it and don't forget to visit my website farhatlectures.com for additional resources for this course and other courses. Good luck, study hard and stay safe.