Valuing High Yield Bonds: a Business Modeling Approach by Thomas S. Y. Ho President Thomas Ho Company, Ltd 55 Liberty Street, 4B New York, NY 10005-1003 USA Tel: 1-212-571-0121 @ and Sang Bin Lee Professor of Finance School of Business Administration Hanyang University 17 Haeng-dang-dong Seoul, 133-791 Korea Tel: 0)82-2-2290-1057 leesb@ February 2003 We would like to thank Yoonseok Choi, Hanki Seong, Yuan Su and Blessing Mudavanhu for the assistance in developing the models and in our research. We also would like to thank Owen School, Vanderbilt University, seminar participants for the valuable comments. Any remaining errors are ours.
Abstract This paper proposes a valuation model of a bond with default risk. Extending from the Brennan and Schwartz real option model of a firm, the paper treats the firm as a contingent claim on the business risk. This paper introduces the “primitive firm”, which enables us to value firms with operating leverage relative to a firm without operating leverage. This paper emphasizes the business model of the firm, relating the business risk to the firm’s uncertain cash flow and its assets and liabilities. In so doing, the model can relate the financial statements to the risk and the value of the firm. The paper then uses Merton’s structural model approach to determine the bond value. This model considers the fixed operating costs as payments of a “perpetual debt”, and the financial debt obligations are junior to the operating costs. Using the structural model framework, we relative value the bond to the observed firm’s market capitalization, and provide a model that is empirically testable. We also show that this approach can better explain some of the high yield bond behavior. In sum, this model extends the valuation of high yield bonds to incorporate the business models of the firms and endogenizes the firm value stochastic process, which is a key element in high yield valuation in practice. We have shown that in relating the firm’s business model to the firm value, the resulting firm value stochastic process affects the bond value significantly. 2
Valuing High Yield Bonds: a Business Modeling Approach A. Introduction There has been much research in the valuation of corporate bonds with credit risks in the past few years. The impetus of the research may be driven by a number of factors. Recently there has been a surge of bonds facing significant credit risks, as a result of the downturn of the economy after the burst of the new economy bubble. For example, in the telecommunication sector, a number of firms have declared default because of the excess supply of telecommunication infrastructure and financial obligations. Another reason is the impending change in regulations in risk management. Increasingly regulators are demanding more disclosure of risks from the financial institutions and the measures of credit risks in the firm’s investment portfolio. The financial disclosure would lead to the examination of the adequacy of capital for the firms. Finally, the credit risk model is important to the use of a number of recent financial innovations. These innovations include the collateralized debt obligations, credit default swaps and other credit derivatives that have demonstrated significant growths in the past few years. Credit risk model is important in determining these securities’ values and managing their risks. Valuing bonds with credit risk must necessarily be a complex task. A high yield bond tends to have the business risk of the bond’s issuer. And, therefore, to value of a high yield bond may be as involved as valuing the equity of the issuer. Indeed, both the bonds and the equity of a firm are contingent claims on the firm value. 3
One approach to value a high yield bond is that of Merton (1974). The model views the firm’s equity as a call option on the firm value and applies the Black-Scholes model to value a corporate bond. This approach does not require the investors to know the profitability of the firm and the market expected rate of return of the firm. The model only needs to know the prevailing firm value and its stochastic process. In essence, according to the Merton model, a defaultable bond is a default free debt embedded with a short position of a put option on the firm value, with the strike price equaling the face value of the debt and the time to expiration equaling the maturity of the bond. More generally, models that view a high yield bond as a bond with an embedded put option are called structural models. There are many extensions of the Merton model. One general extension is the use of a trigger default barrier that specifies the condition for default. For example, the Longstaff 1and Schwartz model (1995) allows the firm to default at any time whenever the firm value falls below a barrier. This approach views that a bond has a barrier option embedded in a default free bond. This model is extended by Saa-Requejo and Santa-Clara (1999) which allows for the stochastic strike price and Briys and de Varenne (1997) allow the barrier to be related to the market value of debt. Such extensions assume the stochastic firm value captures all the business risk of the firm. They do not model the business of the firm and they in particular ignore the importance of the negative cash flows of a firm in triggering the event of default. 1 See p792, Assumption 4, Longstaff, ., and . Schwartz, 1995, A Simple Approach to Valuing Risky Fixed and Floating Rate Debt, Journal of Finance, , , 789-819. 4
To avoid such shortcomings, the Kim, Ramaswamy, and Sundaresan model (1993) assumes that the bondholders get a portion of the face value of the bond at default, which is based on the lack of cash-flow to meet obligations. They define the default trigger point as a net cash-flow at the boundary, when the firms cannot pay for the interests and dividends. Brennan and Schwartz use the real option approach to determine the firm value as a contingent claim on the business risk. Using this approach, they model the value of a mining company. The real option valuation approach extends the Merton model to specify the business model of a firm and therefore the approach values the corporate bonds as compound options on the business risks. This paper takes this real option approach to value the high yield bonds. Specifically, we model the business of the firm and its operating cash flows contingent on the business risks. Using the structural model’s compound option concept, we determine the default conditions of a firm, given its capital structure and the business model. In essence, our approach endogenizes the trigger default barrier of the firm using the firm’s business model and the capital structure. Specifically, we propose that firms’ fixed operating costs play a significant role in triggering default of the bond’s debt. When the firm has a negative operating income which cannot be financed internally, the firm must necessarily seek funding in the capital markets. However, if the firm value is low in relation to all the future financial obligations, then the firm may not be able to fund the negative operating income, leading 5
to default. Indeed, some bonds are considered risky because of the firm’s high operating leverage, even though the financial leverage may be low. In comparing with the structural models in the research literature, our model suggests that the firm value stochastic process is not a simple lognormal process. Instead the firm value follows an “option” price process. And the debt is not a risk free bond embedded with a put option. It is embedded with a compound option and it is a “junior debt” to the fixed costs. This approach has broad implications to debt valuation. Our model suggests that the pricing of defaultable bond must include more financial information of a firm, in particular, the financial and the operating leverage of the firm. The model allows for the firm to default before the bond maturity by allowing the negative cash flow to trigger a default. Since the model does not require an exogenously specified trigger default function, but solves for the default condition using the option pricing approach, we can use the model to price the bonds using the firm’s financial statements, which are widely available. Therefore, the model can be tested empirically. In this paper, we will provide some empirical evidence to support the validity of the model. While this paper provides a simple model, but we show that the approach is very general. Extensions of the model will be left for future research. 6
The paper proceeds as follows. We will describe the model in section B, presenting the assumptions made in the model. For the clarity of the exposition, in Section C, we provide a numerical example, showing how the model can be used to market available data. Section D presents some empirical evidence on the validity of the model. Section E discusses some of the implications of the model and, finally, Section F provides the conclusions. B. Specification of the Model This section presents the assumptions of the model. Similar to the Merton model, we assume that the market is perfect, with no transaction costs. We assume that there are corporate and personal taxes such that the assumptions are consistent with the Miller model. The corporate tax rate of the firm is assumed to beτ. In this world, the capital cstructure does not affect the value of the firm. We use a binomial lattice framework to construct the risk processes. We assume that the yield curve is flat and is constant over time at an annual compounding rate ofr. The bond valuation model is based on a real option model. fSpecifically, we begin with the description of the business risk of the firm by depicting pthe primitive firm latticeV(n,i). We then build the firm value latticeV(n,i), which includes some considerations of a valuation of a firm: fixed costs and taxes. Finally, we use the firm value lattice to analyze all the claims on the firm value, based on the Miller and Modigliani framework. 7
1. Primitive Firm The firm, the equity, the debt, and all other claims on the firms are treated as the contingent claims to the primitive firm. Primitive firm is the underlying “security” to all these claims and it captures the business risk of the firm. We begin with the modeling of the business risk. We assume that the firm has a fixed capital asset and the capital asset generates uncertain revenues. The gross return on investment (GRI) is defined as the revenue generated per $1 of the capital asset. GRI is a capital asset turnover ratio. In this simplified model, we consider a firm is endowed with a capital asset that does not depreciate and can generate perpetual revenues. Specifically, we assume that GRI follows a binomial lattice process that is lognormal (or multiplicative) with no drift, a martingale process, where the expected GRI value at any node point equals the realized GRI at that node point (n, i), where n is the time steps and i denotes the state of the world. Specifically: GRI(n+1 , i+1) = GRI (n, i )exp(σ⤠睩瑨⁰牯扡扩汩瑹ⁱⰠ睨敲攠〼焼ㄠ慮搠䝒䤨渫ㄬ
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瑨?⁰牯扡扩汩瑹‱⸠周攠?慲步琠灲潢慢楬楴礠焠楳桯獥渠獯⁴桡琠瑨攠?硰散瑥搠癡汵攠潦⁴桥楳欠潶敲湥⁰敲楯??楳⁴?攠潢獥牶敤楳?琠瑨攠扥杩湮楮獴朠数潦⸠周慣慴栠猬⁴桥潬楳汯?睳?牴楮条汥?灲潣敳猠獴慴敤敬潷㨠? 8
GRI(n,i)=q×GRI(n+1,i+1)+(1−q)×GRI(n+1,i) (1) where −σ1−eq=, σ is the volatility of the risk driver. σ−σe−e We assume that the Miller and Modigliani theory can be extended to the multi-period dynamic model described above. In this extension, we assume that all the individuals make their investment decisions and trading at each node on the lattice. These activities include the arbitrage trades described in the Miller and Modigliani theory. The results of the theory apply to each node. Therefore, there is a cost of capital ρ?慴慣栠湯摥?摥灥湤敮琠潮⁴桥畳楮敳猠物獫湤潴物⁴?桥欠?潦⁴桥楲?鉳牥攠捡獨汯睳Ⱐ睨楣栠摥灥湤渠瑨攠潰敲慴楮朠汥癥牡来⸠?周攠捯獴映捡灩ρ瑡?氠潦散瑯爠楳⁴??攠敤牥煵慴???整?牮?爠瑨??散瑯?畳楮敳?楳??慳獵??湧⁴桡琠瑨攠晩牭慳漠晩硥搠捯獴献⁂礠睡礠潦潮瑲慳琬⁴桥潳琠潦慰楴慬映䵍?瑨敯特獳畭敳⁰慲瑩捵污爠晩牭Ⱐ瑡歩潰湧敲⁴慴桥楮?朠汥癥牡来猠杩癥渮⁔桥潳琠潦?捡灩瑡氠潦楲?捣潲摩?朠瑯⁴桥⁍?散⁴瑳桥⁴潲桥?楳敦?映敥瑨攠慳晲栠晬潷猠潦⁴桥?晩牭⸠䡥牥Ⱐ睥硴敮搠瑨楳数琠潮潦?⁍䴠瑨敯特⁴漠愠扵?獥楮捴敳潲猠湤⁵獥楲?⁷楴栠湯灥牡瑩湧敶敲慧攠慳⁴桥敮捨?慲欠景爠捯??慲楳潮⸠??卩湣攠瑨攠灲潤畣瑩潮⁰牯捥獳猠瑨攠獡?攠潤慴攠潮慣⁴?桥慴瑩捥Ⱐ瑨攠晩牭楳欠楳⁴桥?獡??琠敡捨潤攮⁆潲⁴桩猠⁷牥攠慳睩潮汬?獳畭?⁴桡琠瑨攠映捯捡獴灩瑡氠楳潮獴慮琠楮?慬氠獴慴敳?搠瑩?攮⁁捣潲摩湧⁴漠瑨慮攠?䵩⁍汬潤敲楧?汩慮?⁴桥潲礬⁴桥?牭⁶慬略猠瑨攠 9
present value of all the firms’ free cash flow along all the paths on the lattice. In particular, the lattice of primitive firm value is given as, CA×GRI(n,i)×mpV(n,i)= (2) ρ where m is the gross profit margin. By the definition of the binomial process of the gross return on investment, we have ppσV(n+1,i+1)=V(n,i)e. (3) Further, since the cost of capital of the firm isρⰠ瑨攠晩牭⁰慹猠愠捡獨楶楤敮搠潦?pσpC=V⠬ni?×ρ×e? Therefore the total value of the firmV, an instant before the uudividend payment in the upstate is ppσ V=V×1+ρ×e. (4) ()u pSimilarly, the total value of the firmV, an instant before the dividend payment in the ddownstate is pp−σ V=V×1+ρ×e. (5) ()d 10
Then the risk neutral probability p is defined as the probability that ensures the expected total return is the risk-free return. ppp p×V+1−p×V=1+r×V. (6) ()()udf pppSubstituting V, V, V into equation above and solve for p, we have: ud −σA−e p= (7) σ−σe−ewhere 1+rfA=. 1+ρ Note that as long as the volatility and the cost of capital are independent of the time n and state i, the risk neutral probability is also independent of the state and time, and is the same at each node point on the binomial lattice. We have now changed the measure from market probability to the risk neutral probability. We will use this risk neutral probability to determine the values of the contingent claims. 3. The Firm Value We assume that the firm pays out all the free cash flows. Let the fixed cost be FC, which is constant over time and state. In the case of negative cash flow, we assume that the firm gets tax credits, and the firm raises the funds from equity. This assumption is quite 11
reasonable since tax credits can carry forward for over 20 years, the government in essence participates in the business risks of the firm and it should not affect the basic insight of the model. The cash flow is the revenue net of the operating costs, fixed costs and taxes; CF(n,i)=CA×GRI(n,i)×m−FC×(1−τ). (8) ( This model assumes that the firm has no growth over this time horizon. This assumption is quite reasonable because the high yield companies often cannot implement growth strategies. Further, the model can be extended in a straightforward manner to incorporate growth for firms that growth is important to its bond pricing. Ho and Lee (2004) provides an extension of the model with growth, allowing for optimal investment decisions. The terminal value at each state in the binomial lattice at the horizon date has four components: the present value of the gross profit, the present value of the fixed costs that takes the possibility of future default into account, and the present value of the tax which is approximated as a portion of the pretax firm value, and finally, the cash flows of the firm at each node point. Following the Merton model (1974), we assume that the firm pays no dividends after the planning period and the primitive firm follows a price dynamic described below. pppdV=ρVdt+σVdZ (9) p 12
where dZ is the wiener process. The present value of the fixed costs is determined as a hyper-geometric function, according to Merton (1974), since we assume that the firm can go default in the future and the fixed costs are not paid in full. The lattice of the firm value is determined by rolling back the firm values, taking the cash flows into account. The firm value at the terminal period at each node is CA⋅GRI(n,i)⋅mCA⋅GRI(n,i)⋅mV(n,i)=Max−Φ+CA×GRI(n,i)×m−FC(1−τ), 0 (10) ()cρ−gρ−g where Φ(g)is the present value of the perpetual risky fixed cost, and Φ(g) is the valuation formula of the perpetual debt given by Merton(1973) presented in the Appendix. In the intermediate periods, the firm value is determined by backward substitution, p×V(n+1,i+1)−(1−p)×V(n+1,i)V(n,i)=MaxCA×GRI(n,i)m−FC×(1τ), 0. (11) ()c(1+r)f 4. Debt valuation and the Market Capitalization 13
We assume that the firm value is independent of the debt level. The value of the bond is determined by the backward substitution approach. The stock lattice is the firm lattice net of the bond lattice. We first consider the terminal conditions for the bond to be Min[debt obligation at T, firm value at T]. We then conduct the backward substitutions, such that we apply the valuation rule at each node point: Min [backward substitution bond value + bond cash flow, firm value]. Following the standard methodology, the rolling back procedure leads to the value of the debt at the initial value. The market capitalization of the firm is the firm value net of the debt value. C. A Numerical Illustration We assume that the yield curve is flat and is constant over time at % annual compounding rate. The market premium is defined as the market expected return net of the risk-free rate, which is assumed to be 5%. The tax rate of the firm is 30%, which is assumed to be the marginal tax rate. The model is based on a 5 steps binomial lattice. It is a one factor model, with only the business risk. The model is arbitrage-free relative to the underlying values of a firm that bears all the business risks of the revenues. 14
We use one firm, Hilton Hotels, in the sector of consumer and lodging, as an example to illustrate the implementation of the model. On the evaluation date October 31, 2002, the market capitalization is reported to be $4,944 million, and the stock volatility estimated to be the one-year historical volatility of Hilton’s stock is % and the stock beta is . Using the capital asset pricing model, we estimate that the expected rate of return of the stock r = % + ×5%=%. The financial data is given from the financial statements as follows. The revenue is $2,834 million, with the operating cost of $1,542 million, and fixed cost of $726 million. The capital asset is $7,714 million with the long term debt $5,823 million and interest costs $357 million. Using this data, we can calculate Gross Return on Investment (GRI) = Revenue/Capital asset= Profit margin (m) = (Revenue-operating cost)/Revenue= % 1. The GRI Lattice To generate the GRI lattice, we have to assume the sector cost of capital and the volatility initially to begin the iterative process. Let us assume the cost of capital spread be % and the sector volatility %. The assumed data is an initial input for the non-linear 15
optimization procedure. Using the assumed data, we can calculate the expected returns of the sector (ρ⤠ρ㴠〮〴㔠⬠〮〱㔷‽‰⸰㘰㜠?攠捡渠湯眠摥瑥牭楮攠瑨攠灲業楴楶攠??牭慴瑩捥慳敤渠瑨攠?潤敬㨠?CA×GRI⠬ni?×mp††††††††††††V††⠬n†i?†=†††††††? ρWe can also calculate the cash flow of the primitive firm at each node point. The lattice of cash flow at each state, based on the capital asset of $7,714 million; pCF(n,i)=CA×GRI(n,i)×m. (12) (1+r)f−σ−e(1+ρ)Risk neutral probability: p(n,i)== σ−σe−e 2. The Firm Value The fixed costs of the firm stay the same. Gross margin also remains constant. The firm defaults when the firm cannot finance the fixed costs. All excess cash flows are paid out. Lattice of cash flow at each state: at each node, the cash flow is the revenue net of the operating costs, fixed costs and taxes; CF(n,i)=(CA×GRI(n,i)×m−FC)×(1−τ). 16
The terminal value at each state is given below. By assuming that the long term growth rate g be %, the firm value at the terminal period at each node is CAGRI(n,⋅i)⋅mCA⋅GRI(n,i)⋅mV(n,i)=Max−Φ+CA×GRI(n,i)×m−FC(1−τ), 0 ()ρ−gρ−g where Φ(g)is given in the Appendix. At the terminal date, the time horizon where n=5, the firm value for each node is: State (i)0 1 2 3 4 5 Firm value($mil) Now we roll back the firm value from the terminal value, taking the cash flows into account. In the intermediate periods, the firm value is determined by backward substitution, p×V(n+1,i+1)−(1−p)×V(n+1,i)V(n,i)=MaxCA×GRI(n,i)m−FC×(1τ), 0. ()(1+r)f The resulting lattice is given by: Figure 6 Lattice of the firm value 17
yr2 yr3 yr4 yr5 yr 3. Debt valuation and the Market Capitalization The debt structure of Hilton Hotels is somewhat complicated with eight bonds, given below: Table 1 Debt package of Hilton Hotels Obseved dateMaturityCoupon ratePrincipalPrice# of Using the debt structure given above, we can calculate the promised cash flow of the bonds, which are $ thousands at year 0, thousands for the period from year 1 to year 3, $867,553 and $ thousands at year 4 and 5 respectively. Time 0 1 2 3 4 5 18
Debt cash flow Now, we use the lattice of the firm model and the lattice of the debt cash flow, and use the standard backward substitution procedure to determine the debt value. The resulting lattice of the debt is given below. Figure 8 Lattice of debt value yr2 yr3 yr4 yr5 yr Now, the market capitalization value is the firm value net of the debt value. Finally, given the bond price to be $5,818 million, the internal rate of return is % or the credit risk spread, which is the internal rate of return net of the risk free rate, is 476 basis points. From the two nodes of the first period of the stock lattice and the sector lattice, the lattice of the primitive firm, we can calculate the stock volatility and the sector volatility. 4. Calibration 19
Recap that this procedure thus far has assumed the following input data: long-term growth rate of the firm g, sector volatility σ, sector expected excess return ρⰠ畮摥爠p??牫整⁰牯扡扩汩瑹⸠周敲攠慲攠楮瑨獳牥敮攠捥畮?歮潷湳⸠周敳攠摡瑡牥潴扳敲癥搠摩牥捴汹?⁔桥礠慲攠橵獴氠湩摡瑩瑡?⁴漠敮慢汥⁵猠瑯⁰??捥敤⁷楴栠瑨攠慬杯物瑨?渠摥瑥牭楮楮朠瑨攠扯湤⁶慬略⸠?†䡯睥癥爬⁴桥潤敬敲楶敳⁴桥潬汯睩湧汵⁶??㨠?慲步琠?慰楴?汩?慴楯?湤⁴桥瑯捫?癯污瑩汩瑹Ⱐ??楣栠睥慮扳楲敲散癥瑬⁴?桥獥⁶?汵敳⸠䙵牴??爬潴攠瑨慴⁴桥?捥獳整畲渠潦⁴桥瑯捫慮攠摥瑥牭楮敤礠瑨瑡攠氠䍡䅳灩獥琠偲楣楮朠䵯氠摥慮搠批⁴桥煵慴楯渠扥汯眬⁷桩捨猠扡獥搠潮⁴桥?牫整⁰物楳捥欠潦?潮瑩湧敮琠捬慩?⸠周楳⁰牯癩摥猠瑨慴⁴桩牤潮獴牡楮琠瑯⁴桥潮楮敡爠獥慲捨⁷楴栠瑨牥攠捯湴牯氠癡物慢汥献??䕸捥獳整畲渠⡳瑯捫⤠㴠䕸捥獳整畲渠×s⡳toc散k 瑯vo爩latility/sector volatility (13) Therefore, we can use a non-linear estimation procedure in perturbing the assumed data, the long term growth rate and the sector volatility, such that the model derived value equals to the observed values. Market capitalization and stock volatility = observed market capitalization and stock volatility. Market Capitalization Given Stock vol Calibrated Stock Estimated Stock 20
D. Empirical evidence We use an example of McLeodUSA to demonstrate empirically the relationship between the market capitalization and the bond package value. We show that as the market capitalization of the firm falls, the bond package value would also fall. But, the bond value falls more precipitously than the market capitalization as the firm approaches bankruptcy. We also show that the Merton model of the corporate bond can explain much of this relationship between the market capitalization and the bond value. But the model tends to understate the acceleration of the fall in the bond prices when the market capitalization falls below certain value. We use our model to explain this relationship between the market capitalization and the bond package value. Specifically, we assume that the gross return on investment declines, leading the fall in the market capitalization and the bond value. It is quite reasonable to make this assumption. A source of the financial problem of McLeodUSA was the expectation of the demand for communication had been falling along with an excess supply of the communication networks. As a result, the market revised their expectations of the returns of the assets of McLeodUSA, and hence the fall of GRI. 21
We use the calibrated business model of McLeodUSA. The sector volatility and the implied long term growth rate are estimated to be and respective. Further we add a spread to Treasury curve in discounting the bond such that the bond price equals the observed price initially. The use of a spread is reasonable because we have discussed that bonds tend to have a liquidity spread and a risk premium (a market price of risk for the model risks not captured by the model) in predicting defaults. Referring to Figure 1, the results show that the proposed model provides relatively better explanatory power of the observations than that of the Merton model. In particular, using the proposed model, we predict the precipitous fall of the bond value better than that of the Merton model. The empirical evidence can be explained intuitively. McLeodUSA is a communication company that has significant operating costs. Note that, the debts outstanding do not mature in the next three years and there is no immediate maturity of crisis for the firm in the short run. However, because of the significant fixed cost resulting in losses of the operation, the firm’s operation has to be supported by external financing. When the market revised downwards on the returns of the assets, the market capitalization falls leading to the situation where McLeodUSA fails to have access to the capital market to fund its negative operating costs. In essence, the firm defaults on its operating costs, something that the Merton model would not have considered. Figure 10 Stock value vs. Bond value of McLeodUSA 22
dotted line = Real data Blue line = Merton model dotted line = Business model 002468101214StockValueH啮楴?䉩?汩潮L E. Implications of the Model The proposed model is an extension of the Merton’s structural model, where we have use the relative valuation approach to solve for valuation of the market value of debt. And therefore, we have not used any historical estimation of the survival rate of the bonds, which require the model to hypothesize the appropriate market discount rate for the expected cash flow. Also this approach does not require any assumption of the recovery ratio, which is endogenous in the structural model. When compared with the Merton morm can go default without the crisis of maturity. The dmodel can explain the market observwith a high yield spread, even though BondValueH唺??????????Ldel, this model predicts that the fiefault event can be triggered by the fixed costs. This ation that some firm has low credit rating and traded the market debt to equity ratio is low. 23
This model of the bond price is sensitive to the stock price like the Merton model. The main advantage of the proposed model is to allow us to use more detail information about the firm, and therefore the bond valuation model is more realistic. Finally, the model is empirically testable. The financial data, bond yield spreads and stock prices are relatively accessible. F. Conclusions This paper proposes a valuation of bonds with credit risks. The main contribution of the paper is to introduce the concept of a primitive firm. The primitive firm has neither operating leverage nor financial leverage. Given the risk class of this primitive firm, we can determine the value of a firm with operating and financial leverage, as a contingent claim to the primitive firm. This approach enables us to introduce the business model of a firm in the high yield bond valuation. Relating the high yield bond pricing to the firm’s business is standard in practice. And this approach provides a more robust analytical framework to the practitioners in the high yield area. The model provides intuitive insights into the high yield bond behavior. For example, the model shows that the fixed costs of the firm can be viewed as the “perpetual debt” of the firm, senior to the financial debt obligations. Such a treatment of the fixed costs significantly affects the probability distribution of the event of default of a firm and the valuation of the debt. Furthermore, it shows that the bond price is more sensitive to the market capitalization. As the market capitalization falls, the firm with significant fixed 24
costs would fall precipitously with the market capitalization, before the event of default becomes imminent. For this reason, the model shows that the relationship of the probability of default and the bond price must also dependent on the fixed cost level. This may explain the observation that the rating of the bond tends to lag the market pricing of the bonds. Since the bond rating measures the probability of default, which is different to the bond pricing, as this model shows, the extent of the lag must depend on the firm’s operating leverage. This also suggests that models that use bond value or market capitalization to predict the probability of default can also be erroneous. We show that the bond value depends on both the recovery ratio and the probability of default. Since the recovery ratio depends on the firm’s operating leverage, the firm default probability cannot be related simply to the market capitalization or the bond price, without taking the firm’s business model into account. Finally, the proposed model shows that the use of a primitive firm can has broad implications to future research. The study of the primitive firms for different market sector will enable us to better understand the high yield bond valuation. 25
Appendix The valuation formula of the perpetual debt is given by Merton (1973). 2rf2σ2FC2rrFCσV−2FCff Φ(V,∞)=1−M,2+, () 2222rrσσσVffΓ2+2σwhere V= the primitive firm valueFC= fixed cost per yearr= risk free ratef Γ= the Gamma function (defined in the footnote)²σ=the standard deviation of GRIM(•)= the confluent hypergeometric function (defined in the footnote) abb−FC1bbVVMa,2+a,−=e−(1+a)bFC+eFCaVΓ(2+a)+(1+a)(b−aV)Γ1+a, 2σVbrVVfwhere 2r∞∞2FCfx−1−ta−1−t a=, b=, Γ(x)=ted, and Γ(a,x)=ted22∫∫0xσσ 26
References Briys, E. and F. de Varenne, 1997, Valuing Risky Fixed Rate Debt: An Extension, Journal of Financial and Quantitative Analysis, , , 239-248. Ericsson, J. and J. Reneby, 1998, A Framework for Valuing Corporate Securities, Applied Mathematical Finance, , , 143-163. Ho, Thomas . and Sang Bin Lee, 2004, The Oxford Guide to Financial Modeling. Oxford University Press, New York Longstaff, ., and . Schwartz, 1995, A Simple Approach to Valuing Risky Fixed and Floating Rate Debt, Journal of Finance, , , 789-819. Saá-Requejo, J. and P. Santa-Clara, 1999, Bond Pricing with Default Risk, Working Paper, University of California, Los Angeles. Shimko, D., N. Tejima, and D. Deventer, 1993, The Pricing of Risky Debt when Interest Rate are Stochastic, Journal of Fixed Income, , . Vasicek, O., 1977, An Equilibrium Characterization of the Term Structure, Journal of Financial Economics 5, 177-188. 27
