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

- Default Risk
- Inflation Risk
- Interest-Rate 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 |
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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%

- 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 |
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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 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

- 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.

- 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.

- 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.

- 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

- Moody’s and Standard & Poor’s

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

- Moody’s and Standard & Poor’s

- Investment
- Speculative
- Default

Bond (Credit) Ratings |
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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 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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