Chapter 23 Credit Risk and the Value of Corporate Debt 609
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Figure 23.7 shows that bond ratings do reflect the probability of default. Since 1970 effec-
tively no U.S. bonds that were initially rated triple-A by Moody’s have defaulted in the year
after issue and only 1 in 200 have defaulted within 10 years of issue. (The Aaa default rate
is not plotted in Figure 23.7. It would be invisible.) At the other extreme, half of Caa bonds
have defaulted by year 10. Of course, bonds do not usually fall suddenly from grace. As time
passes and the company becomes progressively more shaky, the agencies revise downward
the bond’s rating to reflect the increasing probability of default.
Rating agencies don’t always get it right. When Enron went belly-up in 2001, investors
protested that only two months earlier the company’s debt had an investment-grade rating.
Rating agencies also did not win many friends during the financial crisis of 2007–2009, when
many of the mortgage-backed assets that had been given a triple-A rating went belly-up. And
when agencies do downgrade a company’s debt, they are often accused of precipitate action
that increases the cost of borrowing.
Ratio Aaa Aa A Baa Ba B C
Operating margin (%) 22.0 17.1 17.6 14.1 11.2 8.9 4.1
Debt ratio 19.3 50.2 38.6 46.2 51.7 72.0 98.0
Cash coverage ratio 28.9 15.1 9.7 5.9 3.5 1.7 0.6❱ TABLE 23.2 How financial ratios differ according to a firm’s bond rating. Median
ratios for U.S. nonfinancial firms by bond rating.
Source: Moody’s Financial Metrics: Key Ratios by Rating and Industry for North American Non-Financial Corporations, December 2013.23-4 Predicting the Probability of Default
Credit Scoring
If you apply for a credit card or a bank loan, you will probably be asked to complete a ques-
tionnaire that provides details about your job, home, and financial health. This information
is then used to calculate an overall credit score.^22 If you do not make the grade on the score,
you are likely to be refused credit or subjected to a more detailed analysis. In a similar way,
◗ FIGURE 23.7
Default rates of
corporate bonds
1970–2012, by
Moody’s rating
at time of issue.
Source: Moody’s Investor
Service, “Annual Default
Study: Corporate Default and
Recovery Rates: 1920–2012.”0102030405060708012345678910Cumulative default rate, %Years after issueCaa-C
B
Ba
Baa A(^22) The most commonly used consumer credit score is the FICO score developed by Fair Isaac & Co., which uses data provided by any
one of three credit bureaus—Experian, TransUnion, or Equifax.