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Maturity

Maturity

For the AAA and BBB ratings, the default spread widen for the longer maturities. For the B rated bonds, the spreads widen as we go from 1 to 3 year maturities but narrow after than. Why might this be? It is entirely possible that this reflects where we are in the economic cycle. In early 2004, there were many cyclical firms that were in trouble because of the recession of the prior 2 years. If these firms survive in the short term (say 3 years), improving earnings will reduce default risk in future years.

The default spreads presented in Table 3.4, after a good year for the stock markets and signs of an economic pickup, were significantly lower than the default spreads a year earlier. This phenomenon is not new. Historically, default spreads for every ratings class have increased during recessions and decreased during economic booms. The practical implication of this phenomenon is that default spreads for bonds have to be re-estimated at regular intervals, especially if the economy shifts from low to high growth or vice versa.

A final point worth making here is that everything that has been said about the relationship between interest rates and bond ratings could be said more generally about interest rates and default risk. The existence of ratings is a convenience that makes the assessment of default risk a little easier for us when analyzing companies. In its absence, we would still have to assess default risk on our own and come up with estimates of the default spread we would charge if we were lending to a firm.

ratings.xls: There is a dataset on the web that summarizes default spreads by bond rating class for the most recent period.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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