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MGT411 - Money & Banking - Lecture Handout 16

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BONDS & SOURCES OF BOND RISK

  • Bonds and Risk
  • Default Risk
  • Inflation Risk
  • Interest Rate Risk
  • Bond Ratings
  • Bond Ratings and Risk
  • Tax Effect

Bonds and Risk

Sources of Bond Risk

  • Default Risk
  • Inflation Risk
  • Interest-Rate Risk

Default Risk

  • There is no guarantee that a bond issuer will make the promised payments
  • Investors who are risk averse require some compensation for bearing risk; the more risk, the more compensation they demand
  • The higher the default risk the higher the probability that bondholders will not receive the promised payments and thus, the higher the yield
  • Suppose risk-free rate is 5%
  • ZEDEX Corp. issues one-year bond at 5%
  • Price without risk = ($100 + $5)/1.05 = $100
  • Suppose there is 10% probability that ZEDEX Corp. goes bankrupt, get nothing
  • Two possible payoffs: $105 and $0
Table: Expected Value of ZEDEX Bond Payment
Possibilities Payoff Probability Payoff × Probabilities
Full Payment $105 0.90 $94.50
default $0 0.10 $0
Expected Value= Sum of Payoffs times Probabilities = $94.50
  • Expected PV of ZEDEX bond payment = $94.5/1.05 = $90
  • If the promised payment is $105, YTM will be $105/90 – 1 = 0.1667 or 16.67%
  • Default risk premium = 16.67% - 5% = 11.67%

Inflation Risk

  • Bonds promise to make fixed-dollar payments, and bondholders are concerned about the purchasing power of those payments
  • The nominal interest rate will be equal to the real interest rate plus the expected inflation rate plus the compensation for inflation risk
  • The greater the inflation risk, the larger will be the compensation for it
  • Assuming real interest rate is 3% with the following information
Probabilities
Inflation Case I Case II Case III
1% 0.50 0.25 0.10
2% - 0.50 0.80
3% 0.50 0.25 0.10
Expected Inflation 2% 2% 2%
Standard Deviation 1.0% 0.71% 0.45%

Nominal rate = 3% real rate + 2% expected inflation + compensation for inflation risk

Interest-Rate Risk

  • Interest-rate risk arises from the fact that investors don’t know the holding period yield of a longterm bond.
  • If you have a short investment horizon and buy a long-term bond you will have to sell it before it matures, and so you must worry about what happens if interest rates change
  • Because the price of long-term bonds can change dramatically, this can be an important source of risk

Bond Ratings

  • The risk of default (i.e., that a bond issuer will fail to make a bond’s promised payments) is one of the most important risks a bondholder faces, and it varies among issuers.
  • Credit rating agencies have come into existence to assess the default risk of different issuers
  • The bond ratings are an assessment of the creditworthiness of the corporate issuer.
  • The definitions of creditworthiness used by the rating agencies are based on how likely the issuer firm is to default and the protection creditors have in the event of a default.
  • These ratings are concerned only with the possibility of the default. Since they do not address the issue of interest rate risk, the price of a highly rated bond may be quite volatile.

Long Term Ratings by PACRA

Investment Grades:

  • AAA: Highest credit quality. ‘AAA’ ratings denote the lowest expectation of credit risk.
  • AA: Very high credit quality. ‘AA’ ratings denote a very low expectation of credit risk.
  • A: High credit quality. ‘A’ ratings denote a low expectation of credit risk.
  • BBB: Good credit quality. ‘BBB’ ratings indicate that there is currently a low expectation of credit risk.

Speculative Grades:

  • BB: Speculative.
  • ‘BB’ ratings indicate that there is a possibility of credit risk developing,
  • B: Highly speculative. ‘B’ ratings indicate that significant credit risk is present, but a limited margin of safety remains.
  • CCC, CC, C: High default risk. Default is a real possibility.

Short Term Ratings by PACRA

  • A1+: highest capacity for timely repayment
  • A1: Strong capacity for timely repayment
  • A2: satisfactory capacity for timely repayment may be susceptible to adverse economic conditions
  • A3: an adequate capacity for timely repayment. More susceptible to adverse economic condition

B: timely repayment is susceptible to adverse changes in business, economic, or financial conditions
C: an inadequate capacity to ensure timely repayment
D: high risk of default or which are currently in default

Bond Ratings and Risk

Bond Ratings

  • Moody’s and Standard & Poor’s

Ratings Groups

  • Investment Grade
  • Non-Investment – Speculative Grade
  • Highly Speculative

Commercial Paper Ratings

  • Moody’s and Standard & Poor’s

Rating Groups

  • Investment
  • Speculative
  • Default
Bond (Credit) Ratings
S & P Moody’s What it means
AAA Aaa Highest quality and credit worthiness
AA Aa Slightly less likely to pay principal + interest
A A Strong capacity to make payments, upper medium grades
BBB Baa Medium grade, adequate capacity to make payments
BB Ba Moderate ability to pay, speculative element, vulnerable
B B Not desirable investment, long term payment doubtful
CCC Caa Poor standing, known vulnerabilities, doubtful payment
CC Ca Highly speculative, high default likelihood, known reasons
C C Lowest rated class, most unlikely to reach investment grades
D   Already defaulted on payments
NR   No public rating has been requested
+ Or - &1, 2, 3 Within-class refinement of AA to CCC ratings

The lower a bond’s rating the lower its price and the higher its yield.

The effect of an increase in risk on equilibrium in the bond market

Increased Risk reduces Bond Demand

  • The resulting shift to the left causes a decline in equilibrium price and an increase in the bond yield.
  • A bond yield can be thought of as the sum of two parts:
  • The yield on the Treasury bond (called “benchmark bonds” because they are close to being riskfree) and
  • A risk spread or default risk premium
  • If the bond ratings properly reflect the probability of default, then lower the rating of the issuer, the higher the default risk premium
  • So we may conclude that when Treasury bond yields change, all other yields will change in the same direction

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