1. DEBT MORTALITY
MARKOV ANALYSIS OF MOODY’S CREDIT RATINGS
Final Project
MAC5116 - Stochastic Processes
Summer 2010
Kevin McLaughlin
2. OUTLINE
Balance Sheet 101
Credit Ratings
Markov Analysis
Moody’s Migration Table
Investment Quality
Canonical Form for Migration Table
Fundamental Matrix
Time Spent in Transient States
Probability of Transition and Absorption
Case Studies
Discussion
Appendix
3. BALANCE SHEET 101
At it’s core, a business can be described by a few basic
components
Assets
Tangible items like property, plant, and equipment
Intangibles like patents, copyrights, and branding
Liabilities
Current (due in 12 mo), money to suppliers, payroll, …
Long term Debt (Bonds, convertibles, & commercial paper)
Shareholder’s Equity
Equity = Assets – Liabilities
What’s left of the assets after paying all liabilities
Assets of a company can be funded by debt OR equity
4. CREDIT RATINGS
Few people realize the global equity, or stock, market
is dwarfed by the bond market
Outstanding bond debt totaled roughly $82 trillion in 2008,
v. about $40 trillion in the stock markets
Companies can survive large drops in equity, but they
generally don’t survive very long when they default
(miss payments) on their bond debts, file for
bankruptcy, or renegotiate loan terms
Ratings agencies like Standard & Poor’s, Moody’s,
and Fitch provide convenient and useful measures of
a company’s financial health
5. MOODY’S RATING - THE SOUTHERN CO.
The Southern Company, parent of Gulf Power, is rated A3,
which is great, but it looks like they may get downgraded
7. MOODY’S LETTER RATINGS
Below is a one-year migration table for Moody’s ratings
Can be further distinguished with numbers (22 in total)
Notice:
Dominance of the diagonal
Heavy weighting to the right of the diagonal
Absorbing states, Default and Withdrawn Rating
Equivalent to financial death
Average One-Year Letter Rating Migration Rates, 1970-2008
From/To Aaa Aa A Baa Ba B Caa Ca-C Default WR
Aaa 88.495 7.618 0.650 0.026 0.028 0.002 0.002 0.000 0.000 3.179
Aa 1.047 86.817 7.077 0.288 0.042 0.016 0.008 0.001 0.016 4.688
A 0.066 2.832 87.274 4.961 0.473 0.086 0.028 0.003 0.024 4.253
Baa 0.043 0.191 4.786 84.382 4.165 0.781 0.203 0.021 0.163 5.265
Ba 0.008 0.056 0.395 5.678 76.054 7.070 0.549 0.061 1.084 9.045
B 0.011 0.037 0.133 0.346 5.034 73.940 5.090 0.620 4.165 10.624
Caa 0.000 0.026 0.037 0.222 0.484 8.928 60.782 3.589 13.122 12.810
Ca-C 0.000 0.000 0.000 0.000 0.331 2.790 9.446 39.479 30.033 17.921
Default 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 100.000 0.000
WR 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 100.000
8. INVESTMENT QUALITY
Total space of Letter Ratings
These ratings can be partitioned into three levels of
investment quality
Investment Grade
Most mutual funds and other retirement-oriented funds are
only allowed to buy investment grade bonds
High Yield (Speculative or Junk)
Only aggressive investors buy this type of debt
Most likely to be mispriced due to market inefficiencies
Default or Withdrawn Rating
CCaCaa,B,Ba,HY,BaaA,Aa,Aaa,IG
WRDefault,C,CaCaa,B,Ba,Baa,A,Aa,Aaa,S
9. CANONICAL FORM FOR MIGRATION TABLE
Transient block
39.4799.4462.7900.3310.0000.0000.0000.000
3.58960.7828.9280.4840.2220.0370.0260.000
0.6205.09073.9405.0340.3460.1330.0370.011
1.0610.5497.07076.0545.6780.3950.0560.008
0.0210.2030.7814.16584.3824.7860.1910.043
0.0030.0280.0860.4734.96187.2742.8320.066
0.0010.0080.0160.0420.2887.07786.8171.047
0.0000.0020.0020.0280.0260.6507.61888.495
CCa
Caa
B
Ba
Baa
A
Aa
Aaa
CCaCaaBBaBaaAAaAaaQ
Recurrent block
17.92130.033
12.81013.122
10.6244.165
9.0451.084
5.2650.163
4.2530.024
4.6880.016
3.1790.000
CCa
Caa
B
Ba
Baa
A
Aa
Aaa
WRDefaultR
11. TIME SPENT IN TRANSIENT STATES
Companies rated Aaa are expected to remain so for
9.312 years, while they can be expected to spend
0.482 years as speculative Ba
Notice the dominance of the diagonal
Tendency to remain at current rating
1.6830.4560.3720.1250.0750.0460.0150.002
0.1732.7331.0490.3200.2240.1390.0470.007
0.0820.6034.3551.0420.6050.3740.1190.020
0.0380.2851.5034.9062.2061.1920.3430.051
0.0230.1750.7771.6758.2353.7301.0150.146
0.0140.1040.4560.9843.83910.7742.5550.310
0.0090.0670.2900.6202.3946.2479.4910.909
0.0070.0520.2240.4821.8264.7576.4329.312
CCa
Caa
B
Ba
Baa
A
Aa
Aaa
CCaCaaBBaBaaAAaAaaQ)-(I -1
12. TIME UNTIL ABSORPTION
Row sum equals the expected number of years spent as
Investment Grade and High Yield entities
After that, the only remaining states are Default and
Withdrawn Rating
The better the current rating, the longer you can expect
a company’s debt to provide you with income
It seems reasonable to invest in Investment Grade debt
with 15-20 year maturities. Similarly, you probably
shouldn’t invest in High Yield debt with maturities greater
than 10 years
,
CCa
Caa
B
Ba
Baa
A
Aa
Aaa
CCaCaaBBaBaaAAaAaaQ)-(I -1
1.6830.4560.3720.1250.0750.0460.0150.002
0.1732.7331.0490.3200.2240.1390.0470.007
0.0820.6034.3551.0420.6050.3740.1190.020
0.0380.2851.5034.9062.2061.1920.3430.051
0.0230.1750.7771.6758.2353.7301.0150.146
0.0140.1040.4560.9843.83910.7742.5550.310
0.0090.0670.2900.6202.3946.2479.4910.909
0.0070.0520.2240.4821.8264.7576.4329.312
2.774
4.693
7.198
10.525
15.776
19.036
20.028
23.092
CCa
Caa
B
Ba
Baa
A
Aa
Aaa
Years
13. PROBABILITY OF TRANSIENT STATE J
The off-diagonal entries represent the probability
of EVER going from rating i to j
Diagonal entries represent the probability of
returning to rating i given that it started with
rating i
Let F = (I-Q)-1, => (F-I) X diag(F)-1
,
CCa
Caa
B
Ba
Baa
A
Aa
Aaa
CCaCaaBBaBaaAAaAaa)Q)-diag((II)-Q)-((I -1-1-1
40.59416.6828.5592.5430.9090.4220.1550.025
10.29263.41624.0906.5202.7151.2940.4950.077
4.85022.05477.03621.2297.3433.4711.2490.216
2.26310.43734.51979.61826.78911.0633.6160.549
1.3726.41417.83834.14387.85734.61610.6911.572
0.8183.82010.47920.04846.61890.71826.9173.327
0.5282.4646.67112.63729.06857.98689.4649.764
0.4071.9095.1559.82622.17444.15167.76989.261
14. ABSORPTION PROBABILITIES
The probability of being downgraded to one of the two
absorbing ratings, given the transient rating on the left
Row sums equal unity
Withdrawal of rating is the most likely scenario
Considered a neutral way of retiring debt
Default risk is drastically more significant for High
Yield rated debt
Debt default is negative for all parties and loss of
investment ensues
41.76058.240
54.17245.828
70.26329.737
83.14016.860
90.5069.494
94.3255.675
96.2753.725
97.1372.863
CCa
Caa
B
Ba
Baa
A
Aa
Aaa
WRDefaultRQ)-(I -1
16. BERKSHIRE HATHAWAY INC.
Run by Warren Buffet, CEO & Chairman, and
Charlie Munger, Vice Chairman
Initially rated Aaa in June of 2001 on $700 million
of shelf debt, which was later used to finance the
purchase of Executive Jet Inc. (NetJets®)
Long-term debt rated Aaa in April 2006
Recently downgraded to Aa in April 2009
Buffet’s age, 79, was significant to rating action
89.3% chance of ever regaining Aaa rating
3.7% chance of defaulting
Outstanding debt expected to last 20 years
Longest dated debt, $1.7B @ 3.2%, matures in 2015
17. GULF POWER COMPANY
Current Rating is A (since at least 1995)
On watch for potential downgrade, as well as
Georgia Power Co., and Mississippi Power Co.
Lower revenues due to the recession (Surprise!)
Lower revenues due to economic impact of BP oil spill
High Capital Expenditures for environmental
compliance over the next several years
FL regulators have not allowed utilities to charge
customers rates that produce expected returns
90.7% chance of regaining A rating if downgraded
5.7% chance of defaulting
Outstanding debt expected to last 19 years
Longest dated debt, $35M @ 5.875%, in 2044
18. NEW ALBERTSON’S, INC.
My first employer (W. 9 Mile & Pine Forest Rd)
Current Rating is Ba
Aa in May 1992
Withdrawn rating in May 1995
Aa in Jun 1995
A in Mar 1999, downgrade
Baa in Jan 2001, downgrade
Ba in April 2006, downgrade
B in May 2006, downgrade
Ba Jan 2009, upgrade
High Yield (Junk) status
16.9% chance of defaulting
Outstanding debt expected to last 10.5 years (or 7.2
years to be conservative)
Longest dated debt, $225M @ 8.7%, in 2030
19. BRITISH PETROLEUM P.L.C.
Recently downgraded to A from Aa
A in May 1995
Aa in Nov 1995, upgrade
A in Jun 2010, downgrade
Still Investment Grade
Risk of default increased to 5.7% from 3.7%
Outstanding debt expected to last 19 years
Initially rated as A. The probability of ever being
upgraded to Aa was 27%. Probability of returning
to A was 91%. 47% chance of Baa rating (still
investment grade)
20. DISCUSSION
Two important safety criteria for debt investors are time
horizon and low default risk. Markov analysis shows the
usefulness of Moody’s rating system for categorizing
investments by these two criteria
Considering the expected time-to-absorption for
Investment Grade debt is longer than 15 years, it makes
sense for retirement oriented investment funds to stick
with these types of debt securities
Similarly, due to their relatively short life spans, and
high default rates, High Yield investments SHOULD be
limited to more discretionary funds with greater
appetite for risk
22. PROFILE OF NEW DEBT ISSUERS
Issuers by Debt Rating Issuers By IG
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1970
1975
1980
1985
1990
1995
2000
2005
Aaa Aa A
Baa Ba B
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1970
1975
1980
1985
1990
1995
2000
2005
Invest Grade Spec Grade
23. REASONS FOR DEFAULT
Moody’s definition of default includes three types of
credit events
A missed or delayed disbursement of interest and/or
principal
Bankruptcy, administration, legal receivership, or other
legal blocks (perhaps by regulators) to the timely payment
of interest and/or principal
A distressed exchange occurs where: (i) the issuer offers
debt holders a new security or package of securities that
amount to a diminished financial obligation (such as
preferred or common stock, or debt with a lower coupon or
par amount, lower seniority, or longer maturity); and (ii)
the exchange has the effect of allowing the issuer to avoid a
bankruptcy or payment default
Taken from “Corporate Default and Recovery Rates,
1920-2008,” February 2009
24. REASONS FOR WITHDRAWAL OF RATINGS
A withdrawn rating signifies the removal of a rating on either an obligation or an
issuer. Withdrawn ratings reflect Moody's current view of the credit at the time
of withdrawal
Inadequate information
Any rating may be withdrawn if, in Moody's opinion, there is insufficient information to
assess effectively the creditworthiness of the issuer or obligation. This would typically
hold in situations where the issuer declines to provide information requested by Moody's
and Moody's cannot otherwise attain the requested information through public channels
Bankruptcy/Reorganization/Liquidation
If the issuer defaults, enters bankruptcy/reorganization or is liquidated, it may no longer
be useful or necessary for Moody's to maintain a rating on the issuer or the issuer's
obligations
Business Reasons
Under certain circumstances, Moody's will withdraw a rating for an issuer or an
obligation for reasons unrelated to the adequacy of information, or bankruptcy or
reorganization status of the credit. When this occurs, Moody's will balance the market
need for a rating against the resources required to maintain and monitor a rating
Maturity of obligation
An obligation rating will be withdrawn when the rated obligation is no longer
outstanding. In practice, the vast majority of WR actions arise from routine debt
maturities, calls, or redemptions
Taken from “Moody’s Guidelines for the Withdrawal of Ratings.” January 2004
