Investments, tenth edition

  Determinants of Bond Safety 

 Bond rating agencies base their quality ratings largely on an analysis of the level and trend 

of some of the issuer’s financial ratios. The key ratios used to evaluate safety are

    1.   Coverage ratios —Ratios of company earnings to fixed costs. For example, the 

 times-interest-earned ratio  is the ratio of earnings before interest payments and 

taxes to interest obligations. The  fixed-charge coverage ratio  includes lease pay-

ments and sinking fund payments with interest obligations to arrive at the ratio of 

earnings to all fixed cash obligations (sinking funds are described below). Low or 

falling coverage ratios signal possible cash flow difficulties.  

   2.   Leverage ratio, debt-to-equity ratio —A too-high leverage ratio indicates excessive 

indebtedness, signaling the possibility the firm will be unable to earn enough to 

 satisfy the obligations on its bonds.  

   3.   Liquidity ratios —The two most common liquidity ratios are the  current ratio  

(current assets/current liabilities) and the  quick ratio  (current assets excluding 

 inventories/current liabilities). These ratios measure the firm’s ability to pay bills 

coming due with its most liquid assets.  

   4.   Profitability ratios —Measures of rates of return on assets or equity. Profitabil-

ity ratios are indicators of a firm’s overall financial health. The  return on assets  

(earnings before interest and taxes divided by total assets) or  return on equity   (net 

income/equity) are the most popular of these measures. Firms with higher returns 

on assets or equity should be better able to raise money in security markets because 

they offer prospects for better returns on the firm’s investments.  

   5.   Cash flow-to-debt ratio —This is the ratio of total cash flow to outstanding debt.    

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  Bond Prices and Yields

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 Standard & Poor’s periodically computes median values of selected ratios for firms in 

several rating classes, which we present in  Table  14.3 . Of course, ratios must be evalu-

ated in the context of industry standards, and analysts differ in the weights they place on 

particular ratios. Nevertheless,  Table 14.3  demonstrates the tendency of ratios to improve 

along with the firm’s rating class. And default rates vary dramatically with bond rating. 

Historically, only about 1% of industrial bonds originally rated AA or better at issuance 

had defaulted after 15 years. That ratio is around 7.5% for BBB-rated bonds, and 40% for 

B-rated bonds. Credit risk clearly varies dramatically across rating classes.  

 Many studies have tested whether financial ratios can in fact be used to predict default 

risk. One of the best-known series of tests was conducted by Edward Altman, who used 

discriminant analysis to predict bankruptcy. With this technique a firm is assigned a score 

based on its financial characteristics. If its score exceeds a cut-off value, the firm is deemed 

creditworthy. A score below the cut-off value indicates significant bankruptcy risk in the 

near future. 

 To illustrate the technique, suppose that we were to collect data on the return on 

equity (ROE) and coverage ratios of a sample of firms, and then keep records of any 

corporate bankruptcies. In  Figure 14.9  we plot the 

ROE and coverage ratios for each firm, using  X

for firms that eventually went bankrupt and  O   for 

those that remained solvent. Clearly, the  X  and  O

firms show different patterns of data, with the sol-

vent firms typically showing higher values for the 

two ratios.  

 The discriminant analysis determines the equa-

tion of the line that best separates the  

X  and  O

observations. Suppose that the equation of the line 

is .75  5  .9  3  ROE  1  .4  3  Coverage.  Then,  based 

on its own financial ratios, each firm is assigned 

a “ Z -score” equal to .9  3  ROE  1  .4  3  Coverage. 

If its  Z -score exceeds .75, the firm plots above the 

line and is considered a safe bet;  Z -scores  below 

.75 foretell financial difficulty.