In recent years, subprime financial crisis effects to the instability in the financial market especially in corporate debt market when the debt financing risks dramatically rise and rapidly change in bond credit rating. With the recessed economy during the crisis time, some firms went bankruptcy while as some encounters the downgrade creditworthiness, in other words, the debt financing risks go up and also the bankruptcy rate around the world increases at the same time. The beginning of subprime rumor after New Century Financial Corporation, the second U.S. largest subprime originator, filed bankruptcy to the court in April 2007. As a result, many banks and financial institutions hit the historical losses on share price and dropped in earnings according to the domino effect, for example, Merrill Lynch recorded the biggest loss in 93 years on a third quarter of 2007 as $ 2.25 billion after wrote down $ 8.5 billion in U.S. subprime mortgage and bond and Citigroup, U.S. largest bank has announced 57% drop in third-quarter earnings from a year earlier after wrote down $3 billion in mortgage loan. And the well-documented collapse of giant firm in this period known as Lehman brothers made innumerable losses in many related companies. With the uncertainty environment during the crisis, the market was changing overtime including the acquisition, take over and merger between many banks and worldwide firms which occurred speedily such as Merrill Lynch is sold to Bank of America, followed by Washington mutual is acquired by the Federal Deposit Insurance Corporation in September 2008. We can see that the effect of subprime loan created big problems on wide range of financial institutions, not only the originator of the loan but also many financial institutions who invest in bonds, those are investment trust, mortgage lender, investment bank and securities company. That is, the spread out of crisis effect goes far beyond what everyone would think of and reached other countries as every could invest in bonds. Moreover, it produced domino effect when one company failed and related companies come into the trouble. The most important one is the high volatility of default probability in bond market after the outbreak of crisis which caused fluctuating of investor perception towards underlying firms' creditworthiness with the fear of insolvency. Hence, the accurate measurement of firms creditworthiness are required in order to determine future bond prices and reduce investors subjected to the uncertainty risk.
Generally, the credit rating agencies have come under scrutiny to predict the default of companies or the likelihood of firm bankruptcy in order to warn investors of financial danger. But we cannot know its accuracy of prediction, for instance, the collapses of Enron and WorldCom in 2001 and 2002 are the evidences of wrong prediction by credit rating agencies. Since the credit rating agencies gave the investment grade ratings for them until Enron and WorldCom went insolvency. It was questioning on the ability of credit rating agencies to rate companies accurately at that point of time. With the effect of subprime financial crisis on many firms' financial positions around the world in recent years, it is questioning that the credit rating agencies can do the correct assessing of firm performance or not when the market adjusts quickly. This is the important task as investors need the information to assess the probability of successful investments and gain the profits from accurate bankruptcy predictions.
Due to the fact that the interest rate in many countries have been declined since the subprime crisis began. This is because Central banks in many countries such as USA, England, China and the European central bank cut interest rates for easing the subprime loans and also boost up the world economy. As a consequence of this, bond becomes a good alternative investment for many investors when people can earn only little profits from bank deposits. However, to invest in corporate bond market, investors will be experienced higher risks and volatility at the time of unstable economy; therefore it is useful to measure the risk of debtor before making the decision.
The purpose of this paper is to find the default probabilities of Thai corporate bonds in each class rating and compare the results with credit rating agencies. According to the outbreak of the subprime crisis, it is worth to assess the default of companies as the probability of bond default has been changing very quickly. After that, using the results to compare the company rating given by the credit rating agencies and then, discuss on accuracy of credit rating agencies.
The nature of corporate bond and risks involved
Corporate bonds are the means which private firms borrow money directly from the public by issuing bonds (Bodie et al.2008). Their bond structures are similar to Treasury bill once issuing companies return face value to the bondholder at maturity and typically pay coupon to the bond purchaser which depends on condition of that particular bond. However, they differ in terms of the degree of risks since corporate bonds have a higher credit risks involved so that they offer higher yields compare with treasury, almost no chance of default. Therefore, investors should concern any risks involved on bonds before making a purchase of corporate bonds such as interest rate uncertainty, reinvestment risk, liquidity risk and the most important one, bond default risk which this paper focuses on.
In finance, default risk on bonds is defined as the risk that corporate issuers will default on their debt obligations, in other words, fail to pay interest and/or principal on their debt obligations (Bodie et al). So, the investors will get loss his entire investment or receive less than the promised return on bond if counter-party goes bankruptcy.
On the other hand, the bondholder can even face the other risks such as delayed payments of interest and/or principal, and the event which called distressed exchanges, the issuer offers a smaller security than the original security (Bystrom and Kwon). Also, the investors will face with interest rate risk which anyone cannot avoid and the liquidity risk when it is hard to sell corporate bonds in the second market. Besides, there are other risk factors that investors should be aware on corporate bonds which are call risk and event risk. According to some corporate bonds are callable bond, allowing the issuer repurchase the bond at specified call price before maturity date, for example, the issuing company issue a bond with high coupon rate at high market interest rate. After that, the market interest rate falls, the firm can purchase the bond back and issue a new bond at lower coupon rate instead. This is because the firm can lower its interest expenses by doing refinance it s debts, however issuing firm can do after the call protection period, the initial time that bond is not callable (Bodie et al.2008). In this case, investors are exposed to reinvestment risk as a result the issuer will call the bond back when interest rate goes down. Event risk is the risk that causes the downgrade of bond abruptly which comes from natural disaster, regulatory change or any circumstances which varies by industry sector (Harper). Another factor that correlates to default risk is bond's length to maturity because the longer maturity of a bond creates higher exposures on economics condition as there is greater chance that bad things can happen. Bond price can adjust anytime to response a change in interest rate, this is called interest rate risk.
Today's financial market
Additionally, nowadays the likely bankruptcy of bond issuer is greater when the debt market becomes more complex with on and off balance sheet securities and related to derivatives. Furthermore, the effect of expansion in derivative market rapidly in recent years with various credit innovations and various mortgage products with the purpose of increasing liquidity and reducing cost of lending caused the growing number of unqualified borrowers. As witnessed from subprime crisis, these derivative products such as mortgage back securities and credit default swap play as significant factors of originating subprime crisis. This is because the failure payment from borrowers of subprime loans made the bad effect to everyone who holds that pool of mortgages security (mortgage back securities) and later effected to the credit insurer, who sells the protection of loans portfolio (credit default swap). We can see that the probability of firm insolvency rose since the subprime mortgage spread out the problems to everyone who holds any type of derivatives linked to the loans without notification. Hence, the chance of firm bankruptcy may be higher than predicted and need more frequency to revise firm financial position during crisis period.
Credit rating agencies
Bodie et al. (2008) states that bond default risk usually called as credit risk, is measured by the credit rating agencies such as Moody's Investor Services, Standard & Poor's Corporation (S&P), and Fitch Investors Service. These agencies use all firm financial information and international sovereign bonds to analyze issuer's creditworthiness and then, published credit ratings of corporate bonds in the forms of letter. As can be seen in table1, these ratings are the most important indicators telling the potential of bond default. The bonds rated below (Baa, BBB) are non-investment grade bonds which have higher risk of default and greater chance to downgrade when compared with those investment grade bonds. Note that the bond's rating can change anytime if firm performance changes or some adverse condition on economy arises. That is, its rating can adjust from the issued rate by downgrading to speculative, junk or default bond. So, the investors should determine on recent news affected on issuer or bond rather than only bond's rating because the news can reach market before credit rating agencies update bond rating. Nevertheless, to examine bond rating and assess its risks involved are still important tasks for investors in order to know bond's quality which mostly use provided bond's grade by credit rating agencies as an indicator of firm's creditworthiness. But it will benefit them if credit rating agencies assess it accurately.
Thai bond market
In 1997 Asian financial crisis aftermath, Thai bond market has expanded tremendously for supporting cash-strapped financial institutions. As a result of crisis at that time, both bond market size and trading volume grew very fast with the huge borrowing for finance budget deficit purpose by financial institution development fund (FIDF). The corporate bond sector also expanded when many companies need to recapitalize and restructure their debts. At the end of 2007, the outstanding bond market value increased eight fold from the value in 1997 as can be seen in table2 (The Thai Bond Market Association).
The structure of the remainder of this paper is as follows. The first section
Yield to maturity
Brigham and Houston (2004) defined yield to maturity as the rate of return earned on a bond if it is held to maturity which we can find yield to maturity on corporate bond by
Kb = k* + IP + DRP + LP + MRP
Whereas; Kd = yield to maturity on corporate bond, k*= Treasury yield, IP = interest premium, DRP = default risk premium, LP = liquidity premium, MRP = maturity premium
Credit spread /Default risk premium
Credit spread is defined as the difference between the yield on corporate bond and government bond at each point of maturity, sometimes called as yield spread (Harper). Normally, the yield on corporate bond is higher than Treasury bill due to the reason that it offers the compensations to investors for bearing higher credit risks as shown in the graph1. Especially, the lower rated bond has high risk of default and also credit migration risk, so credit spread rises associated with additional risks and total yield on that corporate bond will increase as well since its yield comprises of Treasury yield and credit spread. But the default risk on Treasury bill is zero, it can interpret that credit spread represents the default risk on corporate bond or default risk premium (Johnson). That is, the higher the default risk results to higher bond's yield to maturity but lower price.
From the studies on the relationship between default risk premium and state of economy by the Salomon Brothers and the Hutzler, credit spread widened during economic recession but narrowed during economic growth which means that investors concern on bond safety at period of recession rather than during economic expansion. As of the low demand on low grade bonds during recession, this leads to the falling price and thus a higher default risk premium with the widened spread. Conversely, the premium is very small at the period of boom economy because of higher demand on low grade bond since people are less concerned on default risk.
There are two types of default probabilities, real-world default probabilities and risk-neutral default probabilities. Real-world default probabilities are calculated by the historical data while Risk-neutral default probabilities are based on the bond prices (Hull et al). In this paper, it is based on the risk-neutral default probabilities.
Measuring the default risk
From the research of Lawler (1978), he presents that any default risk measure should depend solely on probability of default under the assumption that investors are risk-neutral.