# 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

• 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.

### 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

• 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.

## 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