Issuers defaults

Cross-default clauses. Cross-default clauses state that if an issuer defaults on other borrowings, then the bonds will become due and payable. The definition of which borrowings are covered can vary. The cross-default clause usually carves out defaults in borrowings up to a certain threshold (e.g., 10,000) to prevent a minor trade dispute or overlooked invoice from allowing the bondholders to put the bonds back to the issuer. 

US issuer defaults totaled 136 through the third quarter of 2002, 21% less than the full year 2001 count of 173, but default volume for the nine-month period was 15% higher than full-year 2001 default volume. 

In Europe, the number of issuer defaults increased approximately 40% from 18 for full-year 2001 to 25 through the third quarter of 2002, but default volume exploded, quadrupling from 4.2 billion to 16 billion (see Exhibit 28.7). Although the fallen angel phenomenon did have a material influence on the volume tallies, the more significant variable... 

Investing in bond funds rather than individual bonds might also carry less risk and help to diversify a portfolio. Individual bond investors stand to lose all of their money if the issuer defaults. In contrast, a bond fund holds hundreds of different bonds from different issuers, reducing the effect if one issuer fails to pay interest or principal. 

For lower- and non-rated bonds, the observed effect is the opposite to that of an investment-grade corporate. Over time the probability of default decreases therefore, the theoretical default spread decreases over time. This means that the spread on a long-dated bond will be lower than that of a short-dated bond because if the issuer has not defaulted on the long-dated bond in the first few years of its existence, it will then be viewed as a lower risk credit, although the investor may well continue to earn the same yield spread. 

The different types of bonds in the European market reflect the different types of issuers and their respective requirements. Some bonds are safer investments than others. The advantage of bonds to an investor is that they represent a fixed source of current income, with an assurance of repayment of the loan on maturity. Bonds issued by developed country governments are deemed to be guaranteed investments in that the final repayment is virtually certain. For a corporate bond, in the event of default of the issuing entity, bondholders rank above shareholders for compensation payments. There is lower risk associated with bonds compared to shares as an investment, and therefore almost invariably a lower return in the long term. 

Interest accrues on a bond from and including the last coupon date up to and excluding what is called the value date. The value date is almost always the settlement date for the bond, or the date when a bond is passed to the buyer and the seller receives payment. Interest does not accrue on bonds whose issuer has subsequently gone into default. Bonds that trade without accrued interest are said to be trading flat or clean. By definition therefore,... 

There are two main types of credit risk that a bond portfolio or position is exposed to. They are credit default risk and credit spread risk. Credit default risk is defined as the risk that the issuer will be unable to make timely payments of interest and principal. Typically, investors rely on the ratings agencies—Fitch Ratings, Moody s Investors Service, Inc., and Standard 8c Poor s Corporation—who publish their opinions in the form of ratings. 

The discussion is easily expanded to include risky floaters (e.g., corporate floaters) without a call feature or other embedded options. A floater pays a spread above the reference rate (i.e., the quoted margin) to compensate the investor for the risks (e.g., default, liquidity, etc.) associated with this security. The quoted margin is established on the floater s issue date and is fixed to maturity. If the market s evaluation of the risk of holding the floater does not change, the risky floater will be repriced to par on each coupon reset date just as with the default-free floater. This result holds as long as the issuer s risk can be characterized by a constant markup over the risk-free rate. 

A Z-spread can be calculated relative to any benchmark spot rate curve in the same manner. The question arises what does the Z-spread mean when the benchmark is not the euro benchmark spot rate curve (i.e., default-free spot rate curve) This is especially true in Europe where swaps curves are commonly used as a benchmark for pricing. When the government spot rate curve is the benchmark, we indicated that the Z-spread for nongovernment issues captured credit risk, liquidity risk, and any option risks. When the benchmark is the spot rate curve for the issuer, for example, the Z-spread reflects the spread attributable to the issue s liquidity risk and any option risks. Accordingly, when a Z-spread is cited, it must be cited relative to some benchmark spot rate curve. This is essential because it indicates the credit and sector risks that are being considered when the Z-spread is calculated. Vendors of analytical systems such Bloomberg commonly allow the user to select a benchmark. 

All in all, the secured nature of this type of product strongly reduces the loss potential in a default scenario and to date, since their inception back in 1869, no Cedulas Hipotecarias has ever defaulted. In Moody s opinion these factors justify a rating of two notches above the senior unsecured debt rating for the issuer. 

Under the secured loan structure, the trustee might find it necessary under certain circumstances to enforce the fixed and floating charges. Such circumstances could include unremedied events of default under the issuer-borrower loan, or if third-party creditors were to attempt to put the company into administration. In this case, the trustee would seek to have an administrative receiver appointed on behalf of the secured creditors. However, the process could disrupt the receipt and payment of cash flows. The ratings of the notes are based on timely payment of interest (and sometimes principal) so the transaction will include some form of liquidity support, which is typically sized to enable the issuer to cover one year s debt service. 

Servicer default that would have a material adverse effect on the issuer of the loan notes. 

Recovery rates for individual obligors differ by issuer and industry classification. Rating agencies publish data on the average prices of all defaulted bonds, and generally analysts will construct a database of recovery rates by industry and credit rating for use in modelling the expected recovery rates of assets in the collateral portfolio. 

Since credit default swaps are written on the reference entities, their pricing provide information on the default probabilities of the issuer and are not subject to liquidity premia that can be present in the credit spreads of the credit risky bonds. Therefore, the term structure of credit default swap spreads for a particular issuer is used to determine the cumulative default probability of the issuer. 

Some practitioners argue that Merton models are more appropriate than reduced form models when pricing default swaps on high-yield bonds, due to the higher correlation of high-yield bonds with the underlying equity of the issuer firm. 

While it is not uncommon for active market makers and end users to utilize their own, customized set of tools for credit default swap valuation, many, if not all of these methodologies arise from the same general framework and ask the same two questions What is the probability that a particular issuer will default and, Upon the occurrence of a default event, what does one expect to recover from an issuer ... 

To begin the valuation of a set of cash flows that are subject to an issuer s credit risk, we can define a fictitious issuer ABC, and a cash flow C that is linked to the performance of issuer ABC. If ABC defaults on or prior to the date on which the cash flow C is due to be paid, no cash will be paid at all. It is commonly said that this cash flow is risky since it is subject to the credit risk of issuer ABC. 

Perhaps the most important part of the default swap is the payment the buyer of protection will receive if a default occurs during the life of the swap. After all, this is precisely the protection the buyer is paying for. Upon a default, the buyer of protection will receive the notional amount of the swap after delivering to the seller-defaulted assets of the issuer. We define recovery value, or more briefly R, to be the value of these defaulted assets immediately following the credit event, so it can be more easily stated that upon a default the buyer of protection will receive 100% - R. 

Although the pricing of a credit default swap can be numerically reduced to a model, the inputs to that model still remain subjective. How can one calculate an exact valne for R, the recovery value of an issuer s assets post-default Or, more importantly, how can one calculate the hazard rate X for an issuer What is the probability that a particular issuer will default in five years Determining the true credit risk of an issuer has been a topic of intense focus in recent years and, as a result, quite a variety of methods and models have surfaced. 

Given the lengthy discussion devoted to valuing the credit default swap, it makes perfect sense to be able to solve backwards for X, given observable data in the market. If the default swap market is active for a particular issuer, a trader can observe the premium being paid for default protection directly in the market. With a known value for the premium P, and an assumption for R, the hazard rate X can be extracted. Since there is no initial exchange of cash when a default swap is executed, it... 

This approach is circular and only works well in cases where liquid credit default markets already exist for an issuer. This is not always the case and was definitely not the case when default swaps were first introduced. Nonetheless, it still requires a highly subjective recovery value assumption. 

In the event of a default, there will be no payment of accrued interest by the issuer since generally coupons are not recoverable, so we can ignore that aspect of the valnation. The only component left to the bond is its value upon a default or its recovery value. If a default occurs, the bondholder will lose all future cash flows of the instrument (i.e., they are at risk), but will be left with a nonperforming asset worth R. The same technique is used here as in the default swap—except this time the payout is R rather than 1 - R upon default. Conveniently, this formula is identical to equation (22.11), except that the term (1 - R) is replaced by R. 

Further, if there were a variety of bonds of a particular issuer outstanding, with different maturities, a term structure of hazard rates could be constructed—which in turn could be used to price default swaps of any maturity. By reducing everything to the hazard rate X, we are able to calculate correctly the prices of different instruments regardless of their interest or premium payment frequencies and daycount conventions. Similarly each instrument s mechanics are stripped away (e.g., a default swap versus a bond) to reveal the true hazard rate. 

This discussion covers the main factors affecting bond returns in the European fixed income market, namely, the random fluctuations of interest rates and bond yield spreads, the risk of an obligor defaulting on its debt, or issuer-specific risk, and currency risk. There are also other, more subtle sources of risk. Some bonds such as mortgage-backed and asset-backed securities are exposed to prepayment risk, but such instruments still represent a small fraction of the total outstanding European debt. Bonds with embedded options are exposed to volatility risk. However, it is not apparent that this risk is significant outside derivatives markets. 

Issuers are considered to have defaulted after passing a 30-day grace period unless there is a bankruptcy filing, in which case defaults are immediate. Defaults include distressed exchanges, where bond investors are offered securities with diminished structural or economic terms compared to existing bonds. 

Issuer Par Valu Outstanding (US, 000) Default Month Default Source Fitch Industry... 

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