Principles of Corporate Finance_ 12th Edition

Chapter 23 Credit Risk and the Value of Corporate Debt 613

bre44380_ch23_597-617.indd 613 09/30/15 12:08 PM

◗ FIGURE 23.11 Estimates by Moody’s of the probability that J.C. Penney would default on its

debt in the coming year.

Source: Moody’s Analytics.

Mar

. 2010
Jun. 2010Sep
. 2010
Dec
. 2010
Mar
. 2011
Jun. 2011Sep
. 2011
Dec
. 2011
Mar
. 2012
Jun. 2012Sep
. 2012
Dec
. 2012
Mar
. 2013
Jun. 2013Sep
. 2013
Dec
. 2013
Mar
. 2014
Jun. 2014Sep
. 2014
Dec
. 2014
Mar. 2015

0

2

4

6

8

10

12

14

Expe

cted

prob

ability of

de

fault, %

chances that the value of J.C. Penney’s assets would hit the default point. As the value of the
assets declined, Moody’s assessment of the probability of default increased. By early 2014 it
had reached nearly 10% before falling back.

23-5 Value at Risk

It is November 2014 and you own Boeing 7.95% bonds maturing in 2024. The bonds are
rated A by Moody’s and are currently priced at 140.9% to offer a promised yield to maturity
of 3.1%. If you plan to hold the bonds for the next 12 months, how much risk are you taking?
You may be tempted to look back at past default rates for A-rated bonds and conclude that
there is only a negligible chance that the bonds will default during the next year and therefore
your investment is almost as safe as U.S. Treasuries. But of course this ignores the possibility
that, although default is unlikely in the short term, Boeing’s prospects may not be as good at the
end of the year as they are now. If so, the bonds could be downrated and their value would fall.
Banks and consulting firms have developed a variety of ways to measure the risk of a
deterioration in credit quality. For example, one of the most popular, the CreditMetrics sys-
tem, looks at the possible impact of changes in the bond rating.^24 Table 23.3 shows how
frequently bonds were rerated in the years 1983–2012. Since your Boeing bonds are A-rated,
we will focus on the third row of the table. You can see that in the past nearly 85% of A
bonds were still rated A after one year and a few were even upgraded to Aa or better. How-
ever, the bad news is that after one year 4.5% of A-rated bonds had moved into the category
of Baa or below.
If Boeing’s debt were to be downgraded to Baa, investors would undoubtedly demand a
higher yield. For example, in 2014 the yield on Baa bonds was about 1.6% higher than that
on A bonds. If the yield on your Boeing bonds rose by this amount, the price would fall by

(^24) CreditMetrics was originally developed by JPMorgan Chase.