Fundamentals of Financial Management (Concise 6th Edition)

218 Part 3 Financial Assets

Figure 7-5 that the risk-free rate, or vertical axis intercept, was lower in January

2008 than it was in January 1994, primarily re" ecting the decline in both rates and

expected in" ation over the past few years. Second, the slope of the line has in-

creased, indicating an increase in investors’ risk aversion largely due to the sub-

prime mortgage problem and growing fears of a possible recession. Thus, the pen-

alty for having a low credit rating varies over time. Occasionally, as in 2008, the

penalty is quite large; but at times, as in 1994 (shown in Figures 7-4 and 7-5), it is

small. These spread differences re" ect investors’ risk aversion and their optimism

or pessimism regarding the economy and corporate pro! ts. In 2008, as more and

more homeowners default on their loans and poor economic news continues, in-

vestors were both pessimistic and risk-averse; so spreads were quite high.

Changes in Ratings

Changes in a! rm’s bond rating affect its ability to borrow funds capital and its

cost of that capital. Rating agencies review outstanding bonds on a periodic basis,

occasionally upgrading or downgrading a bond as a result of its issuer’s changed

circumstances. For example, on March 4, 2008, S&P upgraded Reliant Energy’s

secured debt facilities from B to BB–; however, the! rm’s “B” corporate credit rat-

ing remained unchanged. The secured debt’s upgrade was due to the! rm’s re! -

nancing the secured debt with unsecured debt, reducing the size of its secured

revolving loan, and paying down the senior secured notes. On the other hand, on

March 6, 2008, S&P downgraded Airborne Health Inc.’s corporate credit rating

from B– to CCC+. The downgrade was largely due to S&P’s concern about the

company’s future sales following negative publicity from its recent settlement of a

class action lawsuit. (The lawsuit came about from the company’s claims that its

product helped prevent the common cold, a fact that was proved to be untrue.)

1994 1995 1996 1997 1998 1999 2000

U.S. Government

Wide

Spread

Corporate AAA

Narrow Spread

Corporate BBB

Yield (%)

Years

2001 2002 2003 2004 2005 2006 2007 2008

0

2

4

6

8

10

Yields on Selected Long-Term Bonds, 1994–2008

F I G U R E 7! 4

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