Chapter 10 page 5

[Snowy]

The second paragraph from the top of the page:
"In addition, this approach is useful if the sponsor's debt is not traded because it can also provide a benchmark against which to compare measures of creditworthiness that are based directly on bonds."
What does this sentence mean?

 

[Gresham Arnold]

One way of assessing a company's creditworthiness is to look at the yield on its bonds and compare that with the yield on government bonds (which are deemed to be risk-free).

One problem with this approach is that, if a company's bonds are not traded very often, it can be hard to obtain an up-to-date market price or yield.

An alternative approach is to use the Merton model, which uses data about the company's share price to lead to an assessment of the market value of a company's bonds (and hence the yield on those bonds). So, this approach is gives an alternative measure of bond yield and hence creditworthiness.

It might be a particularly valuable approach to use when assessing companies whose debt is infrequently traded but whose shares are often traded.

 

[Snowy]

Sorry, but I still don't understand:

1. "this approach is useful if the sponsor's debt is not traded " part.
Does it mean not traded at all, not traded very often?

2. Your reply says "It might be a particularly valuable approach to use when assessing companies whose debt is infrequently traded but whose shares are often traded." - what is the difference between how often debt is traded vs how often shares are traded?

Thanks

 

[Gresham Arnold]

1) Either - the same issue (ie that the price is inaccurate) occurs whether the debt is not traded at all or is merely not traded very often - although I guess the issue is more severe if the debt is not traded at all.

2) The issue is the same - if debt is traded infrequently the price you have may be out-of-date. Likewise, if shares are traded infrequently the price you have may be out-of-date.