Let's talk for a minute about that risk. That risk maybe composed as we mentioned before, of more than one source. One of them and the most typical one and the most widely discusses what we call default risk. Default risk, remember what is a bond. Someone that promises that's going to pay installments over the period of time up until the maturity day when it's going to give you the face value back. Now, default risk is the probability that doesn't happen, is the probability that the issuer says, "I'm no longer going to pay, maybe because I can't, maybe because I don't want to." Kind of irrelevant for our discussion here today, but the problem is that there's a probability that those cash flows are not going to be paid. Now, that is exactly what rating agencies do. What rating agencies do is basically they go into a government, they go into a company, they go into any issuer, they analyze the government or the company or the issuer more generally and they assess the probability that you're going to pay back or not. They look at your history, they look at your financials, whether you have the ability to pay, whether you have your willingness to pay and basically once they analyze that, they give you what is called a rating, which I'll show you in a couple of a minute. The three largest rating agencies are Standard & Poor's, Moody's and Fitch and there are many others that's why I put some dots there indicating that there may be others, but these three are by far the biggest one. Probably during the 2008, 2009 crisis, you heard these names quite a bit because this whole story that there were bonds that were very highly rated at Indian defaulted, which is not what you would expect and it's not what typically happens, but it does happen and it did happen during the global financial crisis. Going back to where we were, default risk is the probability that you're not going to pay the coupons that you have promised, and there're companies that actually give you a judgment whether that is going to happen or not, or how likely that is going to happen. Now, there's many and let me jump into that. This is actually a table taken directly from the case that I mentioned before, and we're not going to get into all that information. What matters for us is that those letters are what is called credit ratings or simply ratings. They go triple AAA, double AA, A, and as you see there, triple BBB and so forth, all the way to D, and D is basically a bond in default. It's one of those in which the issuer couldn't or didn't want to pay and therefore the bond stop there. That doesn't mean that, that's the end of the story. Typically, when an issuer doesn't pay, they sit together with the owners of the bond and try to negotiate something, but at least as far as we're concerned, the bond is in default. The credit quality decreases as we go from the top to the bottom. That is the highest credit qualities, triple AAA, then double AA then single A then triple BBB, and on and on and on. But not only the credit quality decreases as we go down that ladder, but there's a very important fundamental line, which is right below triple B. On top of the red line that is what we call investment grade bonds. An investment grade bonds as a group. The triple AAA, the double AA, the single A, and the triple BBB, those have a very low probability of default. That doesn't mean that we'll never default, but it means that they have a fairly low probability of default to the point that some investors, by law, can only buy investment grade bonds. For example, if you are a pension fund at the only type of bonds that you can buy are those that have a very low probability of default. Underneath that red line, there's two names for the rest of the bonds, some people call them junk bonds, and some people call them high yield bonds, and These two things are true, they're junk because they have a very high probability of default, but they also offer you as a compensation for that, they offer you a high yield. The bottom line is again, there's no tradeoff and this goes back to the heart of market efficiency. The reason that the Trump bond pays you more than the Motorola Bond and the GE bond and the US government bond is because it's riskier and one of these sources of risk is the probability of default. The bottom line is as we go down that pecking order, the quality of the credit decreases, and therefore, you would have to pay more and more and more for issuing those bonds and people will actually ask you to pay more and more and more to compensate them for the risk. Now, most of those letters, with the exception of triple AAA, have pluses and minuses, so you have the double AA, the single A, the triple BBB, those you can have double AA plus double AA and double AA minus, you can have A plus A and A minus, and on and on and on. The only one that doesn't have a plus is triple AAA. But the bottom line is that this is the way we evaluate whether companies or issuers in general are likely to pay or not. Now, that red line that we were looking at before is very important. This is a case of a Pemex in Mexico, and it says the word downgrade. If you downgraded from triple AAA to double AA, or from double A to single A, or from single A to triple BBB that's usually not a huge deal as long as you rename investment grade. But once you cross that line, once you actually go from investment grade to non investment grade, to junk, to high yield are bonds, then that means that a lot of buyers of your bond will have to sell it. If you're a pension fund, you have to sell that bond. When you sell bonds, that means that the prices will fall and the returns will actually increase. It's very important for a lot of companies, for a lot of issuers to remain investment grade and to move within the investment grade, but not to cross that red lines. Once you do, then a substantial part of the market has to exit you, has to actually sell those bonds and then the pool of potential buyers dries up and that of course, means that you're going to have to pay more to convince people to buy your bonds. The bottom line with that is if we think about well, so how do we come up with this ratings? Well, you don't have to do it. That's what credit rating agencies are for and they look at different variables and we can never guess exactly what they do, but we know some of the variables that are very important. One of them is obvious, which is the debt ratio, how much debt you have relative to the total capital that you have in the company. If we think in terms of corporate bonds. Now, everything else equal the higher debt ratio, the higher the proportion of debt that you have relative to the total capital, the more that you're going to have to pay because the riskier you become. If you have very little debt, then it's very likely that you're going to pay back all those coupons and principal, but if you're very highly indebted because you're in trouble, then that decreases substantially the probability that you're going to pay. You're going to get a bad credit rating and then your return that you have to offer is going to go up. The other is the interest coverage. It's important for another obvious reason, which is this is basically how much profits you have to pay interest on the bond. The more profits you have per dollar of interests that you have to pay, then the safer you are. The less profits that you have relative to the interests that you have to pay, then the more dangerous the riskier you are, and therefore the worse is going to be your rating. Now we could go on and on and we know that there are more variables that matter, but at the end of the day, the debt ratio and the interest coverage are two of the main variables that rating agencies look at in order to determine how much you have to pay, in order to give you the ratings for the company. Now, going back to the four bonds that we have in the case, notice one interesting thing. Remember that triple BBB plus is worse than triple AAA, and double CC is a lot worse than triple BBB and triple AAA. Now, triple AAA and triple BBB plus, those are investment grade. Double C is non investment grade or junk or high yield, however you want to call that. Now, notice that as we move from the US away to the GE Capital to Motorola, then the return that investors go up. Although the rating goes down only once from GE Capital to Motorola. Now it's natural that Motorola pays more because it's less safe, if you will, from a default perspective than GE Capital, but then you can have two bonds with a similar rating as the GE Capital and the US or wait bond are, but they're paying a slightly different, or in this case it's not so slightly the difference between the two. The reason that they pay differently is because there may be other sources of risks that come into play too. But as you see here in this picture, the return that bonds have to pay and the default risk correlate quite highly when the default risk actually go substantially up, meaning that you go from investment grade to non investment grade, as it is the case when you go from Motorola to Trump, look at the spike in the return. Now you have become a lot more risky, which means that you're going to have to pay a very much higher return in order to convince investors to buy those bonds. The bottom line is that the default risk is one of the key ways in which we evaluate the risk of bonds, but it's certainly not the only one.
