Fundamentals of Financial Management (Concise 6th Edition)

Chapter 7 Bonds and Their Valuation 219

Over the long run, rating agencies have done a reasonably good job of measur-
ing the average credit risk of bonds and of changing ratings whenever there is a
signi! cant change in credit quality. However, it is important to understand that
ratings do not adjust immediately to changes in credit quality; and in some cases,
there can be a considerable lag between a change in credit quality and a change in
rating. For example, Enron’s bonds still carried an investment-grade rating on a
Friday in December 2001, but the company declared bankruptcy 2 days later, on
Sunday. Many other abrupt downgrades occurred in 2007 and 2008, leading to
calls by Congress and the SEC for changes in rating agencies and the way they rate
bonds. Improvements can clearly be made, but there will always be surprises
when we learn that supposedly strong bonds were in fact quite weak.

7-8c Bankruptcy and Reorganization

When a business becomes insolvent, it doesn’t have enough cash to meet its interest
and principal payments. A decision must then be made whether to dissolve the
! rm through liquidation or to permit it to reorganize and thus continue to operate.
These issues are addressed in Chapters 7 and 11 of the federal bankruptcy statutes,
and the! nal decision is made by a federal bankruptcy court judge.
The decision to force a! rm to liquidate versus permitting it to reorganize de-
pends on whether the value of the reorganized business is likely to be greater than
the value of its assets if they were sold off piecemeal. In a reorganization, the! rm’s
creditors negotiate with management on the terms of a potential reorganization.
The reorganization plan may call for restructuring the debt, in which case the

Treasury AAA BBB

Yield (%)

3

5

4

6

7

Yield SpreadAAA = 1.0% Yield SpreadBBB = 2.2%

Yield SpreadBBB = 1.3%

Yield SpreadAAA = 0.5% Januar 1994 y

January

2008

0

1

2

9

8

Relationship between Bond Ratings and Bond Yields, 1994 and 2008

F I G U R E 7! 5

Long-Term

Government

Bonds

(Default-Free)

(1)

AAA

Corporate

Bonds

(2)

BBB

Corporate

Bonds

(3)

YIELD SPREADS

AAA

(4)! (2) # (1)

BBB

(5)! (3) # (1)

January 1994 6.4% 6.9% 7.7% 0.5% 1.3%

January 2008 4.3 5.3 6.5 1.0 2.2

Source: Federal Reserve Statistical Release, Selected Interest Rates (Historical Data), http://www.federalreserve.gov/releases/H15/data.htm.