Adjusting Debt for Risk
When we have corporate debt we need to include a term to capture the potential loss from a company not being able to fulfill it’s debt obligations. The equation is:
Equation
Return on Debt = Yield to Maturity – (Probability of default) * Expected Loss Rate
Alternatively put, we might expect the same return on debt, so if we wanted to find the yield to maturity expected for different levels of risky debt we would have the equation as:
Equation
Yield to Maturity = Return on Debt + (Probability of default) * Expected Loss Rate
The way we judge the risk of default is through credit rating agencies. These agencies give ratings to bonds, and through these ratings we are able to judge how risky it is.
Challenge
If AAA rated bonds have 0% chance of default, BBB has 1%, and CCC has 10%, what would the expected yield to maturities be with an average loss of 50% of the value.