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Financial Modeling Topic #11A: Default-Adjusted
Bond Return
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Learning Objectives
• Use transition matrices to compute multi-period default probabilities
• Understand the difference between a bond’s YTM and default-adjusted expected return
• Compute default-adjusted expected bond return given a transition matrix and recovery rate
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YTM vs. Expected Return
• The Yield-to-maturity is sometimes referred to as the “promised yield” because it is the discount that equates the market price to the present value of promised coupon and principal payments.
• The bonds expected return is the discount rate that equates market price to the present value of expected cash flows.
• To compute expected cash flows we need to know the probability of default and the payment in the event of default (Recovery).
• To complicate things further, default can happen immediately or through a gradual degradation of the issuer’s creditworthiness 3
Bond Rating Terminology
• Bond credit ratings are attempts to assess the probability that a company will default.
• Credit Event
– occurrence that suggests a default is likely
– Includes: rating change (also called a rating transition), failure to make bond payment, and declaration of bankruptcy
• Recovery rate
– fraction of par recovered in default
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