To raise funds, firms often issue bonds, which obligate the issuer to make payments of interest, and sometimes principal, to the lender on specified dates. Bond is a form of liability. In general, a liability is a legal or constructive obligation resulting from past events or transactions, the settlement of which leads to a probable cash outflow and may also include future economic costs; another view is that a liability is a present obligation to transfer assets or provide services in the future. One of well-known examples of liabilities is BONDS.
Although bonds are considered less volatile than equity securities, significant risks associated with bonds include:
1. Interest rate (risk that interest rates will change negatively, affecting the value of the bond; several factors affect this: maturity, yield, coupon and any embedded call or put embedded options)
2. Call and prepayment (risk that the bond will be called or repaid early; an investor holding a bond that is called will not receive the remaining coupons and must reinvest the proceeds at current market rates [usually lower than the coupon])
3. Yield curve (risk of experiencing an adverse shift in the term structure market interest rates, short term being riskier than long term)
4. Reinvestment (risk that the investor will receive a lower rate on reinvestment after maturity; factors increasing this risk include high coupon and call features)
5. Liquidity (risk of not being able to sell the bond at its fair value; the wider the bid/ask spread, the lower the liquidity)
6. Volatility (likelihood of fluctuations in interest rates that affect a bond’s value)
7. Inflation (risk that the prices of goods and services rise more than the investors expected)
8. Event (external event causes a change in the credit rating of the borrower; examples include natural disasters, corporate restructuring, and regulatory issues)
9. Sovereign (risk that the government of the borrower’s jurisdiction will change its laws or regulations, negatively affecting the value of the bond)
10. Credit (relative probability of default; some of these risks affect many bonds [e.g., interest rate, yield curve, and credit], but not all risks affect every bond; investors demand higher yields for greater risks)
Terminologies & Special Features of Bonds
Unusual nomenclature is often used when referring to bonds:
- Coupon rate – The stated annual interest rate expressed as a percentage of face value (e.g., 8.75%).
- Time to maturity – Period (in years) until final repayment of principal (e.g., 6.205 years).
- Yield to maturity – The internal rate of return on a noncallable bond.
- Par value -The face value to be repaid on maturity (which is generally $1,000).
- Offer price – The price (expressed as a percentage of par) at which the bond could be purchased in the market (e.g., 72.65).
- Bid price – The price (expressed as a percentage of par) at which the bond could be sold in the market (e.g., 70.25).
- Maturity date – The date on which the final repayment of principal must be made.
- Yield to call – The internal rate of return on a callable bond.
- Bond indenture – Specifies the rights and obligations (the coupon rate, maturity date and total amount issued) of the borrower to the lenders.
- Bond covenants – Contract provisions, both negative and affirmative, that limit the actions of the borrower (e.g., debt/earnings before interest, taxes, depreciation and amortization not to exceed 3.5 times).
- Negative covenants – Prohibitions on the borrower, such as restrictions on asset sales, negative pledge of collateral (i.e., not granting it to other lenders), and restrictions on additional borrowings.
- Affirmative covenants -Actions the borrower promises to perform, such as maintenance of certain financial ratios (e.g., interest coverage of 2.5 times) and the timely payment of principal and interest.
Special Features of Bonds
To a bond, entities may attach call, conversion, retraction, or floating rate features, all of which affect its value:
- Call rights – Many bonds have features allowing the issuer to redeem them at a specific call price (normally at a premium to par) before maturity. If interest rates decline in the future, the entity may decide to redeem the existing bonds at the call price and issue new ones at a lower yield. Obviously, this is valuable to the firm but detrimental to the bondholders. Therefore, as compensation for this risk, callable bonds tend to be issued with higher coupons than similar, noncallable, plain vanilla issues.
- Conversion rights -Conversion rights grant the bondholder an option to exchange the bond for a specified number of equity securities, usually ordinary shares. Unlike call provisions, these benefit the bondholders. Therefore, such securities are issued with lower coupons than similar nonconvertible issues.
- Retraction and extension rights – Retractable bonds give the holder an option to retire them at par on a specific date; conversely, extendable bonds allow the holder to extend the life of the bonds to a second, later maturity date. Since these additional privileges benefit the bondholder, retractable and extendable bonds are issued at slightly lower coupon rates than conventional securities.
- Floating-rate bonds – In most cases, the coupon rate on a bond is fixed; on floating-rate bonds, the coupon varies every three or six months at a premium to some established measure of interest rates, such as the London Inter-Bank Offered Rate (LIBOR) or Canadian
- Prime rate – The foremost risk with floating-rate bonds involves the financial health of the entity; if that deteriorates, investors will demand a higher yield, and the bond prices will decline. Floating-rate bonds adjust to variations in market interest rates but not to changes in the issuer’s financial health.
Credit Risk Of Bonds
Corporate bonds are exposed to three types of credit risks: dangers of default, spreads, and downgrade threats. Let’s overview each of the type:
1. Dangers of Default – Default danger measures an entity’s ability to pay its obligations. Since the probability of bankruptcy may differ widely, default risk ratings provide essential information to creditors. Bond default risks are measured worldwide by rating agencies such as Standard & Poor’s (S&P), Moody’s and in Canada, Dominion Bond Rating Service (DBRS). These agencies provide financial information on entities and credit ratings for securities of large firms and municipalities. All of them assign a letter grade to a security, working downward from AAA (S&P and DBRS) or Aaa (Moody’s). Rating classes are modified with a plus or minus by S&P; ‘high’ or ‘low’ by DBRS; or 1, 2, or 3 suffix by Moody’s (e.g., Aaa1, Aaa2, etc.) to provide a more accurate indicator. Currently, only five U.S. corporations are rated AAA by S&P: Automatic Data Processing, Exxon Mobil, Johnson & Johnson, Pfizer, and Microsoft. Since early 2009, General Electric has not been included in the list.
Summary of Bond Ratings
Bond Rating Determination
Bond ratings are based largely on analyses of five groups of financial ratios:
- Coverage – Measures of earnings to fixed costs, such as times interest earned and fixed-charge coverage; low or declining figures signal possible difficulties.
- Liquidity – Measure of ability to pay amounts coming due, such as current and quick ratios.
- Profitability – Measures rates of return on assets and equity; higher profitability reduces risks.
- Leverage – Measures of debt relative to equity; excess debt suggests difficulty in paying obligations.
- Cash flow to debt – Measures cash generation to liabilities.
The next table provides the median financial ratios for Moody’s ratings. When there is no rating available for an entity, the median ratios can be used to develop a proxy rating.
The Enterprise Risk Management [an S&P’s Tool]
In the third quarter of 2008, S&P introduced Enterprise Risk Management (ERM) analyses into its corporate ratings. The object is to identify deterioration or improvements in credit standings before they are observed in the financial statements.
An entity’s ERM is set at one of four levels: weak, adequate, strong, and excellent:
- Missing complete controls for one or more major risks
- Limited capabilities to consistently identify, measure and comprehensively manage risk exposure and limit losses
- Losses may be widespread on a set of predetermined risk/loss tolerance guidelines
- Risk and risk management may sometimes be considered in the firm’s corporate judgment
- Manages risk in separate silos
- Maintains complete control processes because the firm has capabilities to identify, measure and manage most major risk exposures and losses
- Firm risk/loss tolerance guidelines are less developed
- Unexpected losses are somewhat likely to occur
- Risk and risk management are often important considerations in the firm’s corporate judgment
- Demonstrates an enterprise-wide view of risks while still focused on loss control
- Has control processes for major risks, giving them advantages due to lower expected losses in tough times
- Can consistently identify, measure and manage risk exposures and losses in predetermined tolerance guidelines
- Unlikely to experience unexpected losses outside of its tolerance levels
- Risk and risk management are usually important considerations in the firm’s corporate judgment
- Possesses all the characteristics of a ‘strong’ ERM program
- Demonstrates risk/reward optimization
- Very well-developed capabilities to consistently identify, measure and manage risk exposures and losses within the entity’s predetermined tolerance guidelines
- Risk and risk management are always important considerations in the firm’s corporate judgment
- Highly unlikely that the firm will experience losses outside of its risk tolerance
2. Credit Spreads – The term “credit spread” refers to divergence in yields of bonds with differing credit ratings. The next graph plots the behavior of U.S. yields for various credit ratings since 2004.
Credit spreads narrow during expansions and broaden during recessions/contractions. In a recession, investors become concerned about the perceived risk in corporate bonds as defaults become more likely. Hence, investors in nearly all countries move some money out of corporate bonds into government bonds, causing the prices of corporate bonds to fall and their yields to rise. Conversely, the price of government bonds rise and their yields fall, widening the spread; in a period of an expansion, the opposite holds true.
Interpreting credit spreads in this environment. In most countries, credit spreads have become larger; in Canada, for example, at the peak of the credit crisis (December 2008), credit spreads reached record levels.
A-Rated Corporate Bond Spread
Source: Company reports and CIBC – World Markets Inc.
However, care must be taken when interpreting corporate bond spreads during extreme environments (such as the present) because of:
- Liquidity premiums – Numerous studies have sought to explain observed credit spreads that, historically, tend to exceed those explicable by the probability of default; the latter is often reasoned as the single theoretical source of such credit spreads in an efficient market. At least part of the nondefault component of the spread is commonly attributed to liquidity premiums—required incremental returns to compensate for the comparative lack of liquidity of corporate bonds. Such lack of marketability and the related liquidity premium is likely to rise disproportionately during times characterized by flights to quality and rising default rates. Illiquidity in economic conditions may reflect more accurately the deteriorating credit quality and solvency of debt owners rather than of the borrowers themselves.
- Asymmetric returns – In tough economic times, when the probability of corporate default rises, the negatively skewed asymmetry in corporate bond returns (i.e., the fat left tail) relative to share returns is enhanced. Thus, it would be reasonable to expect the risk premiums of corporate debt to rise disproportionately to those of equities.
- Difficulty in diversifying – The negative return asymmetry inherent in corporate bonds further implies that an extraordinarily large number of bonds must be held to obtain adequate diversification of nonsystemic risk; this may result in incremental corporate credit spreads during difficult economic times.
- Impact of taxes – As corporate bond and share valuations decline and corresponding yields rise, the higher tax rates associated with bond interest may lead to a proportionately larger increase in their yields relative to those of dividend yields to maintain tax equivalence.
3. Downgrade Threats – A firm’s credit rating can change; an improvement in a rating of C to BBB is referred to as an upgrade while changes from a BBB to a C is a downgrade. For investment-grade bonds, the probability of a downgrade is much higher than that of an upgrade. Investors lose money when a bond is downgraded, as its price falls to give the higher yield necessary to compensate for the greater risks.
A useful tool for gauging downgrade threats is “the rating transition matrix“, available for 1-year, 2-year, 5-year and 10-year bonds; those with a longer term have a lower probability of retaining their original rating:
The rows of the matrix indicate the rating at the start of a year, while the columns indicate the ratings at the end of the first year. There is a 10.6% probability that an AA-rated bond will be downgraded by the end of any year and a 0.6% probability that it will be upgraded, 16.5 to 1 odds.