Defaults and Returns on High Yield Bonds: Analysis Through September 30, 2002

The third-quarter 2002 default rate for high yield bonds was 4.95%, based on $37.48 billion of defaults. The quarterly default rate is the highest in history, surpassing the first quarter of 1991 rate of 4.80$28.30 billion of defaults (76%). Without WorldCom, the third quarter default rate would have only been 1.2%. The dollar weighted default rate for the first three quarters has already broken the record for a single calendar year reaching 10.98%. And, the latest four-quarters’ default rate of 15.01% has also set a record. Again, WorldCom’s huge default contributed about 4% of this record total. The persistently high default rate through the third quarter has resulted in a near record yield spread of 10.10% -- second only to 1990’s 10.50%. The current yield spread is more than 5% above the historical average. We believe the default rate has peaked in Q3-2002 and depending on the size of the decline, we believe the huge yield spread could reflect an over-sold market. Counting WorldCom ($46.0 billion in liabilities), there were more than$197 billion in liabilities of firms which filed for Chapter 11 protection through the third quarter and 26 firms had liabilities greater than $1 billion. The count was 22 firms through the first-half of the year, so the third-quarter number was "only" four, including WorldCom. There were 39 of such firms in 2001 - - a record year

AN ANALYSIS AND CRITIQUE OF THE BIS PROPOSAL ON CAPITAL ADEQUACY AND RATINGS

This paper has examined two specific aspects of stage 1 of the (BIS's) Bank for International Settlement's proposed reforms to the 8% risk-based capital ratio. We argue that relying on "traditional" agency ratings could produce cyclically lagging rather leading capital requirements, resulting in an enhanced rather than reduced degree of instability in the banking and financial system. Despite this possible shortcoming, we believe that sensible risk based weighting of capital requirements is a step in the right direction. The current risk based bucketing proposal, which is tied to external agency ratings, or possibly to internal bank ratings, however, lacks a sufficient degree of granularity. In particular, lumping A and BBB (investment grade corporate borrowers) together with BB and B (below investment grade borrowers) severely misprices risk within that bucket and calls, at a minimum, for that bucket to be split into two. We examine the default loss experience on corporate bonds for the period 1981-1999 and propose a revised weighting system which more closely resembles the actual loss experience on credit assets

Market Size and Investment Performance of Defaulted Bonds and Bank Loans: 1987-2002

# The defaulted and distressed, public and private debt markets in the United States increased enormously to a record $942 billion (face value) at the end of 2002. The market value of this increasingly attractive alternative investment segment was approximately$512 billion. # Defaulted securities performed below average in 2002; absolute returns, as measured by our various defaulted debt indexes, were - 6.0% on bonds, +3.0% on bank loans, and - 0.5% on the combined defaulted public bonds and private bank loans index. The Altman-NYU Salomon Center Index of Defaulted Bonds grew to a face value of $61.5 billion. The market-to-face value ratio of the Bond Index fell to 0.17 from 0.21 one year ago. The face value of our Defaulted Bank Loan Index was$37.7 billion and the market-to-face value ratio dropped to a record low level of 0.46 by the end of 2002. # The recovery rate on defaulted bonds (price just after default) was very low at 25 cents on the dollar; likewise, the weighted average bank loan recovery rate in 2002 dropped to 52 cents on the dollar. With new defaulted bonds rising in 2002 to a record $96.9 billion (default rate of 12.8%) and the default outlook for 2003 high, but lower than for 2002, investment opportunities should abound in the distressed debt market. # Indications are that distressed investors (both old and new entities) are successfully raising funds because investor expectations are buoyant

Defaults and Returns in the High Yield Bond Market: The Year 2003 in Review and Market Outlook

High yield bond defaults in 2003 declined significantly from record 2002 levels closing the year at $38.5 billion for a default rate of 4.66improvement from the 25companies had issues that were investment grade sometime prior to default. These fallen angels accounted for 33The high-yield bond market returned an impressive 30.62near record level of$137.4 billion; the vast majority was used for refinancing existing loan and bond issues. Based on our mortality rate methodology and assuming different measures of credit risk of recent new issuance, we expect default rates to continue their decline in 2004 to between 3.2% - 3.8%, with rates increasing in 2005 to above 4.0%

Market Size, Investment Performance, and Expected New Supply of Defaulted Bonds & Bank Loans: 1987-1999

This report presents results and discussion of the investment performance of those bonds and bank loans that have defaulted on their scheduled payments to creditors and continue trading while the issuing firm attempts a financial reorganization. Monthly total return measures are compiled based on the Altman-NYU Salomon Center Indexes of Defaulted Bonds and Defaulted Banks Loans, as well as an index that combines bonds and loans. These returns are compared to the total returns of common stocks and high yield corporate bonds. Returns are based on our market-weighted indexes and presented for the past year (1999), as well as for the last 13 years (for bonds) and four years for bank loans. We also estimate the expected supply of new defaulted debt in the United States for the coming three years. Nineteen ninety-nine was a mixed year for investors in distressed debt securities. Although the Defaulted Public Bond Index increased by a respectable 11.34% in 1999, the positive rate of increase was mainly a function of the excellent performance over a threemonth period in the earlier part of the year (February, March and April) when the size of the index was comprised of a relatively small number of securities and when the movement of a few issues had a significant influence on the Index. Still, the positive annual performance reversed the negative annual returns that we had observed in the prior two years. On a comparative note, our Defaulted Public Bond Index’s return of 11.34% was slightly higher than Salomon Smith Barney’s Bankrupt Bond Index return of 8.42%. Defaulted bank loans did not fare as well, recording a slight increase for the year of 0.65%. Except for the initial year (1996) of our Bank Loan Index, performance has been lackluster in the past three years. Finally, the Combined Public Bond and Private Bank Loan Index recorded a positive annual return in 1999 of 4.45%, resulting in a basically flat performance over the four years of the combined index calculation period. Comparative returns for the thirteen-year period (1987-1999), show that common stocks strengthened its number one asset class return/risk position. High yield bonds, while performing relatively poorly in 1999 (+1.7%), maintained a slight average annual return advantage over defaulted bonds. The two “bright” or positive factors related to the defaulted bond and bank loan markets in 1999 were the enormous increase in the supply of new defaulted issues and the record low average market value to face value ratio of the Index at the end of the year. The size of the Index more than doubled in number of issues and tripled in face and market values over the past twelve months as the default amount of high yield bonds reached a record high level in 1999 and the default rate went from 1.6% to over 4.0% (see our companion report on Defaults and Returns in the High Yield Bond Market). Based on our forecast of future defaults, we expect the number and amounts of the issues in both the Bond and Bank Loan indexes to continue to grow, albeit at a lower rate, in the next three years. Going forward, we suggest that this increased supply, and the relatively low marketto-face value ratio of defaulted bonds at the end of 1999, may present significant investment opportunities

AN ANALYSIS AND CRITIQUE OF THE BIS PROPOSAL ON CAPITAL ADEQUACY AND RATINGS

This paper has examined two specific aspects of stage 1 of the (BIS’s) Bank for International Settlement’s proposed reforms to the 8% risk-based capital ratio. We argue that relying on “traditional” agency ratings could produce cyclically lagging rather leading capital requirements, resulting in an enhanced rather than reduced degree of instability in the banking and financial system. Despite this possible shortcoming, we believe that sensible risk based weighting of capital requirements is a step in the right direction. The current risk based bucketing proposal, which is tied to external agency ratings, or possibly to internal bank ratings, however, lacks a sufficient degree of granularity. In particular, lumping A and BBB (investment grade corporate borrowers) together with BB and B (below investment grade borrowers) severely misprices risk within that bucket and calls, at a minimum, for that bucket to be split into two. We examine the default loss experience on corporate bonds for the period 1981-1999 and propose a revised weighting system which more closely resembles the actual loss experience on credit assets

AN INTEGRATED PRICING MODEL FOR DEFAULTABLE LOANS AND BONDS

In recent years, credit risk has played a key role in risk management issues. Practitioners, academics and regulators have been fully involved in the process of developing, studying and analyzing credit risk models in order to find the elements which characterize a sound risk management system. In this paper we present an integrated model, based on a reduced pricing approach, for market and credit risk. Its main features are those of being mark to market and that the spread term structure by rating class is contingent on the seniority of debt within an arbitrage-free framework. We introduce issues such as, the integration of market and credit risk, the use of stochastic recovery rates and recovery by seniority. Moreover, we will characterize default risk by estimating migration risk through a "mortality rate", actuarial based, approach. The resultant probabilities will be the base for determining multi-period risk-neutral transition probability that allow pricing of risky debt in the trading and banking book

Market Size and Investment Performance of Defaulted Bonds and Bank Loans: 1987-2002

The defaulted and distressed, public and private debt markets in the United States increased enormously to a record $942 billion (face value) at the end of 2002. The market value of this increasingly attractive alternative investment segment was approximately$512 billion. Defaulted securities performed below average in 2002; absolute returns, as measured by our various defaulted debt indexes, were - 6.0% on bonds, +3.0% on bank loans, and - 0.5% on the combined defaulted public bonds and private bank loans index. The Altman-NYU Salomon Center Index of Defaulted Bonds grew to a face value of $61.5 billion. The market-to-face value ratio of the Bond Index fell to 0.17 from 0.21 one year ago. The face value of our Defaulted Bank Loan Index was$37.7 billion and the market-to-face value ratio dropped to a record low level of 0.46 by the end of 2002. The recovery rate on defaulted bonds (price just after default) was very low at 25 cents on the dollar; likewise, the weighted average bank loan recovery rate in 2002 dropped to 52 cents on the dollar. With new defaulted bonds rising in 2002 to a record $96.9 billion (default rate of 12.8%) and the default outlook for 2003 high, but lower than for 2002, investment opportunities should abound in the distressed debt market. Indications are that distressed investors (both old and new entities) are successfully raising funds because investor expectations are buoyant