Finance 203: Notes on Bond Ratings1Bond Rating Determinants Interest coverage S&P consider five ratios Profitability S&P uses two ratios pretax return on capital operating margin operating income to salesFinance 203: Notes on Bond Ratings2Bond Rating Determinants Leverage S&P uses two ratio LT debt to assets Total debt to assets Size measure of maturity? more diversified?Finance 203: Notes on Bond Ratings3Bond Rating Determinants Risk measures equity beta equity volatility cash flow variability Finance 203: Notes on Bond Ratings4Coverage Ratios Pretax interest coverage EBIT/interest Pretax interest coverage including rents EBIT/interest+rents Pretax funds flow interest coverage Cash flow from operations/interestFinance 203: Notes on Bond Ratings5Coverage Ratios Funds from operations to total debt Cash flow from operations/total debt Free operating Cash flow to total debt UFCF/total debtFinance 203: Notes on Bond Ratings6Blume, MacKinlay study “The Declining Credit Quality of US Corporate Debt, Myth or Reality,” Journal of Finance, 1998. Related bond rating to interest coverage pretax interest coverage operating coverage sizeFinance 203: Notes on Bond Ratings7Blume, MacKinlay study Two leverage measures LT debt to Value Debt to value Size log of ratio of equity market cap to CPI beta volatility standard errorFinance 203: Notes on Bond Ratings8Blume, MacKinlay study Results Most important variables are LT debt to value and size Second most important is interest coverage, if interest cover is low Third most important is volatilityFinance 203: Notes on Bond Ratings9Blume, MacKinlay study fourth most important is the operating margin fifth most important is betaFinance 203: Notes on Bond Ratings10Blume, MacKinlay study Conclusion: credit rating criteria are being applied more stringently over time same quality of credit as measured by the variables is receiving a lower rating intercept term in regression is declining