174 CHAPTER 4 Bonds and Their ValuationImportance of Bond Ratings Bond ratings are important both to firms and to
investors. First, because a bond’s rating is an indicator of its default risk, the rating has a
direct, measurable influence on the bond’s interest rate and the firm’s cost of debt. Sec-
ond, most bonds are purchased by institutional investors rather than individuals, and
many institutions are restricted to investment-grade securities. Thus, if a firm’s bonds
fall below BBB, it will have a difficult time selling new bonds because many potential
purchasers will not be allowed to buy them. In addition, the covenants may stipulate
that the interest rate is automatically increased if the rating falls below a specified level.
As a result of their higher risk and more restricted market, lower-grade bonds have
higher required rates of return, rd, than high-grade bonds. Figure 4-4 illustrates this
point. In each of the years shown on the graph, U.S. government bonds have had the
lowest yields, AAAs have been next, and BBB bonds have had the highest yields. The
figure also shows that the gaps between yields on the three types of bonds vary over
time, indicating that the cost differentials, or risk premiums, fluctuate from year to
year. This point is highlighted in Figure 4-5, which gives the yields on the three types
of bonds and the risk premiums for AAA and BBB bonds in June 1963 and August2001.^16 Note first that the risk-free rate, or vertical axis intercept, rose 1.5 percentage
points from 1963 to 2001, primarily reflecting the increase in realized and anticipated
inflation. Second, the slope of the line has increased since 1963, indicating an increase
in investors’ risk aversion. Thus, the penalty for having a low credit rating varies over
time. Occasionally, as in 1963, the penalty is quite small, but at other times it is large.
These slope differences reflect investors’ aversion to risk.
TABLE 4-2 Bond Rating Criteria; Three-Year (1998–2000) Median Financial Ratios
for Different Bond Rating ClassificationsRatiosa AAA AA A BBB BB B CCC
EBIT interest coverage (EBIT/Interest) 21.4 10.1 6.1 3.7 2.1 0.8 0.1
EBITDA interest coverage (EBITDA/Interest) 26.5 12.9 9.1 5.8 3.4 1.8 1.3
Funds from operations/Total debt 84.2 25.2 15.0 8.5 2.6 (3.2) (12.9)
Free operating cash flow/Total debt 128.8 55.4 43.2 30.8 18.8 7.8 1.6
Return on capital 34.9 21.7 19.4 13.6 11.6 6.6 1.0
Operating income/Sales 27.0 22.1 18.6 15.4 15.9 11.9 11.9
Long-term debt/Long-term capital 13.3 28.2 33.9 42.5 57.2 69.7 68.8
Total debt/Total capital 22.9 37.7 42.5 48.2 62.6 74.8 87.7Note:
aSee the Source for a detailed definition of the ratios.
Source:Reprinted with permission of Standard & Poor’s, A Division of The McGraw-Hill Companies.
http://www.standardandpoors.com/ResourceCenter/RatingsCriteria/CorporateFinance/2001CorporateRatingsCriteria.html.(^16) The term risk premiumought to reflect only the difference in expected (and required) returns between two
securities that results from differences in their risk. However, the differences between yields to maturityon
different types of bonds consist of (1) a true risk premium; (2) a liquidity premium, which reflects the fact
that U.S. Treasury bonds are more readily marketable than most corporate bonds; (3) a call premium, be-
cause most Treasury bonds are not callable whereas corporate bonds are; and (4) an expected loss differen-
tial, which reflects the probability of loss on the corporate bonds. As an example of the last point, suppose
the yield to maturity on a BBB bond was 8.0 percent versus 5.5 percent on government bonds, but there was
a 5 percent probability of total default loss on the corporate bond. In this case, the expected return on the
BBB bond would be 0.95(8.0%) 0.05(0%) 7.6%, and the risk premium would be 2.1 percent, not the
full 2.5 percentage points difference in “promised” yields to maturity. Because of all these points, the risk
premiums given in Figure 4-5 overstate somewhat the true (but unmeasurable) theoretical risk premiums.