Introduction
The term "bond" refers to a variety of assets that offer a wide range of interest rate payments from fixed cash payments, to accruals without cash where if a bondholder is entitled to receive interest on a bond, they will record that interest income as it accrues, even if the cash hasn't been received yet, to payments in the additional securities.
When an organization needs to raise funds, it typically has a few options, with equity issuance, debt financing from banks, or issuing bonds being among the most common.
- Equity Issuance:
- This involves selling ownership stakes in the company, often in the form of stocks or shares.
- When an organization issues equity, it sells a portion of itself to investors in exchange for cash.
- This can be done through initial public offerings (IPOs) or private placements.
- Equity issuance dilutes existing ownership stakes but does not require repayment of funds.
- Debt Financing from Banks:
- Organizations can borrow money directly from banks or other financial institutions.
- This usually involves taking out loans that need to be repaid over a specified period, along with accrued interest.
- These loans can be secured (backed by collateral) or unsecured, depending on the terms negotiated between the borrower and the lender.
- Debt financing requires repayment with interest but does not dilute ownership.
- Issuing Bonds:
- Bonds are debt securities issued by corporations, governments, or other entities to raise capital.
- When an organization issues bonds, it essentially borrows money from investors who purchase the bonds.
- Bonds typically have a fixed interest rate (coupon rate) and a maturity date at which the principal amount must be repaid.
- Interest payments are made periodically (usually semiannually) until the bond matures.
- Bonds provide a way to raise large amounts of capital upfront but also involve regular interest payments and repayment of principal at maturity.
The choice between these options depends on factors such as the organization's financial situation, risk tolerance, and strategic goals.
Bond Trading
- Publicly traded bonds are usually traded in the over-the-counter (OTC) markets as opposed to exchanges.
- Dealers exist in the bond market to buy and sell bonds and earn profit through the bid-ask spread (e.g. buy low, sell high).
- Bond pricing is based on the laws of supply and demand.
- If demand > supply then prises rises
- If demand < supply then prises falls
- Corporate bond yield
- A corporate bond yield is a function of the risk free return + a credit spread to reflect the risk of default.
- A corporate bond yield curve is a graphical representation of the relationship between the yield (interest rate) offered by corporate bonds of different maturities (the time until the bond matures and the investor gets their money back).
- It essentially shows you how much return you can expect on your investment based on how long you're willing to lend your money.
- Yield:
- This is the annual return an investor receives by holding a bond until maturity.
- It's typically expressed as a percentage.
- Maturity:
- This is the length of time until a bond reaches its maturity date and the issuer needs to repay the principal amount borrowed.
- Bonds can have maturities ranging from a few months to several decades.
- Corporate Bonds:
- These are debt instruments issued by corporations to raise capital.
- Investors who buy corporate bonds essentially loan money to the company in exchange for a fixed interest rate payout over time and the return of the principal amount at maturity.
- The Y-axis of the corporate bond yield curve represents the yield (interest rate), and the X-axis represents the maturity of the bond.
- By plotting yields of corporate bonds with similar credit quality but different maturities, we can see the shape of the curve.
- There are three main shapes a corporate bond yield curve can take:
- Upward Sloping Curve:
- This is the most common scenario.
- It indicates that investors typically demand higher yields for lending money for longer periods.
- This can reflect expectations of rising interest rates in the future or a risk premium associated with longer-term investments.
- Downward Sloping Curve:
- This is less common and suggests that investors are willing to accept lower yields for longer maturities.
- This might occur when there's an expectation of falling interest rates or a flight to safety during economic uncertainty, where investors prioritize security over higher returns.
- Flat Curve:
- This indicates minimal yield difference between short-term and long-term bonds.
- It can be a sign of an economy with uncertain future interest rate movements.
- Inverse Relationship between Bond Prices and Yields:
- When bond yields rise, bond prices fall, and vice versa.
- This fundamental relationship is known as the bond pricing rule.
- It occurs because as yields increase, newly issued bonds offer higher interest payments, making existing bonds with lower yields less attractive to investors.
- To compensate for the lower interest payments, the prices of existing bonds must decrease to bring their yields in line with the market rate.
- Relationship between Bond Liquidity and Investor Demand:
- Higher bond liquidity generally means that a bond can be bought or sold more easily without significantly impacting its price.
- Bonds with higher liquidity tend to have lower bid-ask spreads and higher trading volumes.
- However, higher liquidity may also indicate lower demand by investors.
- This can occur when investors perceive lower risks associated with the bond, leading to less urgency in buying or selling it.
- Conversely, bonds with lower liquidity may have higher demand from investors seeking higher returns, but they may also come with higher transaction costs and greater price volatility.
- Price of bond is the function of demand and supply impacted by interest rate (coupons), market interest rate and time.
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Bond Indenture and Corporate Trustee
- A bond indenture and a corporate trustee play essential roles in facilitating the issuance and management of the bonds.
- The bond indenture defines the terms of a corporate bond issue, while the corporate trustee acts as a guardian of bondholders' interests and ensures compliance with those terms.
- Together, they help to facilitate smooth and transparent bond issuance and management processes.
- Bond Indenture
- A bond indenture is a legal contract between the issuer of the bonds (the corporation) and the bondholders.
- The document that provides clarity and certainty to both the issuer and the bondholders regarding their rights, obligations, and recourse in various scenarios.
- It is usually a detailed document filled with legal language.
- Principal Amount:
- The amount of money borrowed by the corporation, which will be repaid to the bondholders at maturity.
- Coupon Rate:
- The interest rate paid to bondholders, typically expressed as a percentage of the bond's face value and paid at regular intervals (e.g., annually or semi-annually).
- Maturity Date:
- The date when the principal amount of the bond becomes due and payable to the bondholders.
- Call Provisions:
- Terms specifying whether the issuer has the right to redeem the bonds before their maturity date, and under what conditions.
- Covenants:
- Restrictions or requirements imposed on the issuer to protect the interests of bondholders, such as limitations on additional debt issuance or requirements for maintaining certain financial ratios.
- The trustee would monitor corporation's activities to make sure the issuer abides by the indenture's covenants.
- Negative or restrictive
- What company should not do
- E.g. limited additional debt financing, dividend declarations
- Positive
- What company have to do
- E.g. to produce financial statements, maintain insurance
- Financial
- Financials donts and dos
- E.g. maintaining key ratios above/below a given number
- Default and Remedies:
- Procedures and remedies in case of default by the issuer, including potential acceleration of repayment or appointment of a trustee to act on behalf of bondholders.
- Corporate Trustee:
- A corporate trustee is a financial institution or trust company appointed to represent the interests of bondholders and ensure compliance with the terms of the bond indenture.
- One of the roles of the corporate trustee is to interpret the legal language and represent the interests of the bond holders.
- By serving as an independent third party, the corporate trustee helps to enhance transparency, accountability, and trust in the bond issuance process, benefiting both issuers and investors.
- Requirements are explicitly stated in the indenture, and the trustee only needs to meet those requirements and no more.
- The indenture would specify how and the frequency with which the trustee would make reports to bondholders and what to do if the issuer failes to pay interest or principal.
- Typically a corporate trustee is a bank, financial institution, or a highly reputable individual.
- Safeguarding Bondholder Interests:
- The trustee ensures that the issuer complies with the terms of the bond indenture and protects the interests of bondholders.
- Payment Administration:
- The trustee typically receives interest and principal payments from the issuer and distributes them to bondholders in accordance with the bond terms.
- Making sure the number does not exceed the limit specified in the indenture.
- Enforcement of Rights:
- In the event of default or other breaches of the bond indenture, the trustee may take legal action on behalf of bondholders to enforce their rights and seek remedies.
- Record Keeping:
- The trustee maintains records of bond ownership, transactions, and communications with bondholders.
Bond Issuers
- Bond issuers come from various sectors, each with its own characteristics and reasons for issuing bonds.
- There are five general groups of bond issuers:
- Utilities
- Utilities include companies that provide essential services such as electricity, water, and natural gas.
- These companies often have stable cash flows and predictable revenue streams, making them attractive candidates for issuing bonds.
- Utilities may issue bonds to finance infrastructure projects, upgrade facilities, or refinance existing debt.
- Transportation companies
- Transportation companies encompass a wide range of entities involved in transporting goods and people, including airlines, railroads, shipping companies, and logistics firms.
- These companies may issue bonds to fund capital expenditures, expand their fleets, or improve infrastructure.
- Bond investors may be attracted to transportation bonds based on factors such as the stability of the industry, economic growth projections, and government regulations.
- Insdustrials
- Industrial companies span various sectors, including manufacturing, construction, technology, and consumer goods.
- These companies may issue bonds for purposes such as financing expansion projects, acquiring new equipment, or restructuring debt.
- Bond investors assess industrial bonds based on factors such as the company's financial health, competitive position, and industry outlook.
- Financial institutions
- Financial institutions include banks, insurance companies, and other financial intermediaries.
- These entities may issue bonds as a means of raising capital to support lending activities, meet regulatory requirements, or manage liquidity.
- Bond investors evaluate financial institution bonds based on factors such as the institution's creditworthiness, regulatory environment, and interest rate risk.
- Internationals
- International organizations such as the World Bank and the International Monetary Fund (IMF) issue bonds to raise funds for development projects, provide financial assistance to member countries, or support global economic stability.
- These bonds, often referred to as sovereign or supranational bonds, are typically backed by the issuing organization's creditworthiness and may carry concessional terms for certain projects or regions.
- Each group of bond issuers has its own risk profile, financial characteristics, and market dynamics.
- Investors consider factors such as credit quality, industry trends, economic conditions, and geopolitical risks when evaluating bonds issued by these entities.
- Diversifying across different types of issuers and sectors can help investors manage risk and achieve their investment objectives.
Bond Maturities
- Short term bond notes maturities from 1 to 5 years.
- Medium term bond notes have maturities from 5 to 12 years.
- Long term bond notes have maturities from greater than 12 years.
- Tenor of 0-1 year is not called as bond but called as bill.
Bonds Types basis on Interest Payment
- Fixed-rate bonds
- Fixed-rate bonds, as the name suggests, have a predetermined interest rate that remains constant throughout the life of the bond.
- Fixed Interest Rate:
- Fixed-rate bonds pay a specified interest rate, known as the coupon rate, at regular intervals (such as annually or semi-annually) until the bond matures.
- This interest rate is determined at the time of issuance and remains unchanged, regardless of fluctuations in market interest rates.
- Interest Payments:
- The issuer of the fixed-rate bond is obligated to make periodic interest payments to bondholders based on the fixed coupon rate.
- These payments provide a predictable income stream for investors.
- Maturity:
- At maturity, the issuer repays the principal amount (face value) of the bond to the bondholders.
- Fixed-rate bonds typically have a specified maturity date, at which point the bondholder receives the final interest payment along with the repayment of the principal.
- Foreign Currency Payments:
- In some cases, fixed-rate bonds may offer interest payments in a foreign currency.
- This feature is known as a foreign currency bond.
- For example, a U.S. based investor may purchase a bond issued by a European company that pays interest in euros rather than U.S. dollars.
- Foreign currency payments introduce currency exchange rate risk for investors.
- Fluctuations in exchange rates between the foreign currency and the investor's home currency can affect the value of interest payments received.
- Investors need to consider this risk when investing in foreign currency bonds.
- Fixed-rate bonds are popular among investors seeking stable income streams and predictable returns.
- They provide a level of certainty regarding future cash flows, which can be advantageous for income-oriented investors, pension funds, and institutional investors.
- However, investors should carefully assess the credit quality of the issuer, prevailing market conditions, and currency risk when evaluating fixed-rate bonds for investment.
- Floating-rate bonds
- Floating rate bonds, also known as variable rate bonds, are bonds whose interest rates fluctuate over time based on changes in a specified benchmark interest rate or reference rate.
- Interest Rate Structure:
- Unlike fixed-rate bonds where the interest rate remains constant, floating rate bonds have variable interest rates that adjust periodically according to a predetermined formula.
- This formula typically ties the bond's interest rate to a benchmark rate or a reference rate, such as LIBOR (London Interbank Offered Rate) plus a fixed spread or a government bond yield or PLR (Primary Lending Rate).
- While both LIBOR (London Interbank Offered Rate) and the primary lending rate, often referred to as the prime rate, are interest rate benchmarks, they serve different purposes and are used in different contexts.
- The prime rate primarily applies to domestic short-term lending within a specific country, while LIBOR is used in global financial markets for various currency denominations and maturities.
- Benchmark Rate:
- The benchmark rate serves as the reference point for determining the bond's interest rate.
- Coupon rate changes as benchmark rate changes.
- Common benchmark rates used for floating rate bonds include short-term interbank lending rates or government bond yields.
- For example, a floating rate bond may pay interest at a rate equal to LIBOR plus a specified spread.
- Interest Adjustment Frequency:
- The interest rate (coupon) to be paid is determined at the beginning of the period and the interest is paid at the end of the period.
- Floating rate bonds typically have predefined intervals at which the interest rate adjusts. This could be monthly, quarterly, semi-annually, or annually, depending on the terms of the bond.
- Interest Rate Floor and Ceiling:
- Some floating rate bonds include provisions that set a floor and/or a ceiling on the interest rate adjustments. The floor ensures that the bond's interest rate does not fall below a certain level, while the ceiling caps the maximum interest rate that can be paid on the bond.
- Investor Protection Against Interest Rate Risk:
- Floating rate bonds offer investors protection against interest rate risk, as the interest payments adjust in response to changes in prevailing market interest rates.
- When interest rates rise, the interest payments on floating rate bonds increase, helping to preserve the bond's value.
- Conversely, when interest rates fall, the interest payments decrease, but this is typically less of a concern for investors as they still receive higher interest payments relative to fixed-rate bonds.
- Floating rate bonds are attractive to investors, particularly during periods of rising interest rates, as they offer the potential for higher income compared to fixed-rate bonds.
- They are commonly issued by governments, financial institutions, and corporations seeking to manage interest rate risk while still accessing the bond market for financing.
- However, investors should carefully consider the credit quality of the issuer, the terms of the bond, and prevailing market conditions before investing in floating rate bonds.
- Zero-coupon bonds (ZCB)
- Zero-coupon bonds, also known as discount bonds or deep discount bonds, are a type of fixed-income security with some unique characteristics.
- Key features of zero-coupon bonds:
- No periodic interest payments:
- Unlike traditional bonds, zero-coupon bonds don't make any regular coupon payments (interest payments) throughout their lifespan.
- Sold at a discount:
- These bonds are issued and sold at a significant discount to their face value (maturity value).
- This discount represents the investor's return on investment.
- Profit at maturity:
- When the bond reaches its maturity date, the investor receives the full face value, essentially pocketing the difference between the discounted purchase price and the face value.
- Implied Yield:
- The yield to maturity (YTM) of a zero-coupon bond is the annualized rate of return that investors earn if they hold the bond until maturity.
- Since zero-coupon bonds do not make periodic interest payments, their yield is based on the difference between the purchase price and the maturity value, compounded over the holding period.
- Price Volatility:
- Zero-coupon bonds are more sensitive to changes in interest rates compared to coupon-paying bonds.
- This is because their entire return is derived from the difference between the purchase price and the face value, so any change in interest rates can have a magnified impact on their price.
- Bankruptcy and Bondholder Rights:
- Zero-coupon bonds do have an implicit interest component, and understanding how bankruptcy impacts them is essential.
- Implicit Interest in Zero-Coupon Bonds:
- Even though there are no regular coupon payments, a zero-coupon bond's value increases year after year.
- This growth reflects the implicit interest earned on the investment.
- The discount you receive at purchase represents the compounded interest you would have earned on a traditional bond with the same face value and maturity.
- Impact of Bankruptcy on Zero-Coupon Bonds:
- Unfortunately, zero-coupon bondholders don't enjoy the same level of protection as traditional bondholders in case of issuer bankruptcy.
- Since they don't receive regular interest payments, their claim on the issuer's assets is limited.
- If the company goes bankrupt before maturity, bondholders are typically only entitled to:
- The original discounted purchase price they paid for the bond.
- Accrued interest up to the bankruptcy date. This accrued interest is calculated based on the implicit interest and not any actual coupon payments.
- In the event of issuer bankruptcy before the bond matures, bondholders may be entitled to receive the accrued interest up to the date of the bankruptcy filing, in addition to the return of the bond's original issue price. This accrued interest reflects the compensation that the bondholders have earned for holding the bond until the issuer's default, based on the implicit interest embedded in the bond's appreciation in value.
- Here's an analogy:
- Think of buying a zero-coupon bond like buying a discounted train ticket.
- The discount represents the total fare you would have paid if you bought regular tickets with included seat reservations (coupons).
- With a zero-coupon bond, you get the discounted upfront price, but if the train company goes bankrupt before your trip (maturity), you might only get a refund for the initial discounted price, not the full face value of the ticket (maturity value).
- Key takeaway:
- While zero-coupon bonds offer potential benefits like guaranteed returns and interest rate stability, their vulnerability in bankruptcy situations is a crucial consideration for investors.
- It's important to weigh the risks and rewards before adding them to your portfolio.
- Example:
- Let's say you buy a 10-year zero-coupon bond with a face value of $10,000 for $6,000.
- You hold the bond for 10 years and receive no interest payments during that time. However, at maturity, you get the full $10,000 face value.
- Your profit is the difference between the purchase price and the maturity value, which is $4,000 ($10,000 - $6,000).
- This $4,000 represents your effective return on investment over the 10 years.
- Benefits of zero-coupon bonds:
- Reinvesting interest:
- Unlike coupon (coupon means interest) bonds, the zero coupon bondholders does not have to make an effort to reinvest cash interest payments or worry about the available rates in which to reinvest them.
- Can be considered both as both has advantage and disadvantage associated with it, like seeing the glass half full or half empty.
- Guaranteed return:
- As long as you hold the bond until maturity, you are guaranteed to receive the face value, locking in your return at the time of purchase.
- Compounding:
- While you don't receive regular interest payments, the effective return from the discount can be thought of as compounding over time.
- Interest rate stability:
- Zero-coupon bonds can be attractive for investors seeking protection from fluctuating interest rates because the return is locked in at purchase.
- Tax jurisdictions:
- Zero-coupon bonds can be the potential tax benefit of converting interest income to a capital gain.
- Traditional Bond Taxation:
- Coupon bonds typically have regular interest payments that are taxed as ordinary income in most jurisdictions.
- This means investors pay income tax on the interest they receive each year.
- Zero-Coupon Bonds and Tax Advantages:
- With zero-coupon bonds, there are no regular interest payments.
- The investor's return comes from the difference between the discounted purchase price and the face value received at maturity.
- In some tax jurisdictions, this difference may be considered a capital gain rather than ordinary income.
- Capital Gains vs. Ordinary Income:
- Capital gains tax rates are often lower than ordinary income tax rates in many countries.
- This means that investors might pay less tax on their overall return from a zero-coupon bond compared to a traditional coupon bond with the same yield if taxed as ordinary income.
- Important Considerations:
- Tax laws and treatment of zero-coupon bonds can vary significantly between countries and even states or provinces within a country.
- It's crucial to consult with a tax advisor to understand the specific tax implications of zero-coupon bonds in your jurisdiction.
- Even if capital gains are taxed favorably, other factors like the bond's creditworthiness, liquidity, and interest rate sensitivity should also be considered before investing.
- Drawbacks of zero-coupon bonds:
- Reinvesting interest:
- You don't receive any cash flow until maturity, so you can't reinvest the interest payments to potentially grow your returns faster.
- Price volatility:
- The price of zero-coupon bonds fluctuates more than traditional bonds with coupon payments due to changes in interest rates.
- Tax implications:
- Even though you don't receive any cash interest, the IRS may consider a portion of the increasing value as taxable income each year (accrued interest).
- Who should consider zero-coupon bonds?
- Long-term investors:
- These bonds are suitable for investors with a long-term investment horizon who can hold the bond until maturity.
- Investors seeking predictable returns:
- They can be appealing to investors who prioritize a guaranteed return at maturity over regular cash flow.
- Those planning for a future event:
- They can be useful for planning for a specific future event, such as a child's education, where you know you'll need the money at a certain time.
- Remember: Zero-coupon bonds are a specific type of investment with their own set of advantages and disadvantages. It's crucial to carefully consider your investment goals, risk tolerance, and investment timeframe before deciding if zero-coupon bonds are a good fit for your portfolio.
Bond Types based on Collateral
- Corporate bonds can have collateral, such as real property, underlying the issue.
- The collateral may be useful if a defaulting firm will be liquidating because the sale proceeds from the collateral will be paid first to the bondholders who have a collateral position. This serves as a form of protection for investors in case of default.
- If the defaulting firm is reorganized, then the bondholders with collateral will have better negotiating powers. The collateral serves as a bargaining chip, as the company would need your consent to sell or use it for other purposes. This can give you a stronger voice in the restructuring process and potentially lead to a more favorable outcome.
- Bonds can be classified into two main types based on whether they are secured by collateral or not:
- Secured Bonds:
- These bonds are issued with a specific asset pledged as collateral.
- This collateral acts as security for the investor in case the issuer defaults on the bond.
- If a default occurs, the lender can seize and sell the collateral to recoup their losses. Secured bonds typically offer lower interest rates to investors compared to unsecured bonds because they are considered less risky.
- Collateral based bonds: Mortgage bonds, Collateral trust bonds, Equipment trust certificates
- Unsecured Bonds:
- These bonds are not backed by any specific collateral.
- Instead, they rely solely on the creditworthiness of the issuer to repay the debt.
- Unsecured bonds, also known as debentures, generally offer higher interest rates to investors to compensate for the increased risk.
- Mortgage bonds:
- Mortgage bonds have supporting collateral that can be sold to pay off the bondholders if there is a default.
- Restricting future bond issues
- Restricting future bond issues, commonly known as a negative pledge covenant.
- This is a common covenant included in mortgage bond indentures that restricts the issuer (typically a bank) from issuing new debt secured by the same pool of mortgages.
- By doing so, it safeguards the interests of existing mortgage bondholders by ensuring that the collateral pool remains intact and isn't diluted by additional debt obligations.
- Analogy, would be like saying your friend can't use their existing car (or any other car they own in the future) as collateral for other loans without your permission.
- After-acquired clause
- An after-acquired clause could be used to restrict any assets acquired after the bond issuance to be used as collateral only for the existing bonds (and not new bond issues), thereby safeguarding the interests of existing bondholders.
- This prevents the issuer from pledging newly acquired assets to secure additional debt, thereby maintaining the value of the collateral backing existing bonds.
- Analogy, imagine you lend a friend money to buy a specific car (original collateral). An after-acquired clause would be like saying they can't use any future cars they buy (after-acquired assets) as collateral for other loans without your permission.
- In summary, while both provisions aim to protect the interests of bondholders, the negative pledge covenant specifically restricts the issuer from using the same pool of assets for additional debt issuances, whereas the after-acquired clause restricts the use of newly acquired assets as collateral for future bonds.
- Collateral trust bonds
- Collateral trust bonds serve as a form of debt financing where the bonds are backed by various assets such as stocks, notes, bonds, or other similar obligations owned by the issuing company. These underlying assets, referred to as collateral or personal property, provide security for the bondholders in case of default.
- Collateral Trust Bond Structure:
- Collateral: Backed by a pool of financial assets such as stocks, bonds, or notes owned by the issuing company. These assets act as security (similar to personal property in a traditional secured loan).
- Issuer: Typically holding companies, which use claims on their subsidiaries (essentially, IOUs from their own companies) as collateral.
- Trustee: A third-party entity that holds the collateral on behalf of the bondholders(and not the shareholders), ensuring their rights are protected.
- Issuer Considerations:
- Voting Rights:
- The issuer might retain voting rights for the stock used as collateral, as long as they are not in default.
- This allows them to maintain some control over their subsidiaries.
- Indenture Provisions:
- The bond indenture may specify actions if the value of the collateral falls below a certain threshold (compared to the loan value).
- For example, the issuer may have to contribute additional securities to back the bonds to maintain the collateral's value.
- Overall, collateral trust bonds offer a unique way for companies to raise capital by leveraging their existing assets. However, the complex structure involving a trustee and potential limitations on voting rights require careful consideration by both issuers and investors.
- Equipment trust certificates (ETCs)
- ETCs share some similarities with mortgage bonds but are designed specifically for financing specific equipment.
- Similarities to Mortgage Bonds:
- Secured Debt:
- Both ETCs and mortgage bonds are secured by a specific asset (equipment for ETCs, real estate for mortgages).
- This collateral provides security to investors in case of default.
- Pass-through Structure:
- Similar to mortgage bonds, the proceeds from leasing the equipment (or property payments in mortgages) are passed through to the investors who hold the ETCs.
- Differences from Mortgage Bonds:
- Underlying Asset:
- ETCs are backed by a single piece of equipment, while mortgage bonds are backed by a pool of mortgages.
- Ownership Structure:
- The usual arrangement is that the borrower does not actually purchase the equipment. Instead, the trustee purchases the equipment and leases it to the user of the equipment (the effective borrower), who pays rent on the equipment, and that rent is passed through to the holders of the ETCs.
- With mortgage bonds, the borrower typically already owns the property and grants a lien on it.
- Transfer of Title:
- Upon full payment, the title for the equipment is transferred to the lessee (borrower) in an ETC.
- This rarely happens with mortgage bonds, as the homeowner usually keeps ownership after the mortgage is paid off.
- Resale Potential:
- It is especially attractive if the equipment is standardized, like aircraft financed through ETCs can be easily leased to another borrower if needed.
- Mortgaged properties are less fungible and resale may take longer.
- Additional Points:
- Tax Benefits:
- ETCs can offer tax advantages, particularly in North America.
- Since the lessee doesn't own the equipment initially, they may not have to pay property taxes on it until the lease is complete.
- Focus on Specific Industries:
- ETCs are commonly used in industries where equipment is a significant expense, such as airlines financing airplanes or railroads financing locomotives.
- Overall, ETCs offer a unique financing option for companies that require specific equipment. The secured nature and potential for resale of standardized equipment make them an attractive option for both investors and borrowers.
- Debentures:
- Debentures are unsecured bonds, meaning they are not backed by specific collateral.
- Because of this lack of security, debentures generally carry higher interest rates compared to secured bonds, like mortgage bonds or collateral trust bonds.
- In the event of default, debenture holders rank below secured bondholders in terms of priority for repayment.
- To manage risk and protect the interests of debenture holders, certain provisions are often included in debenture agreements:
- Restriction on Additional Issues:
- If the issuer already has secured debt, there may be restrictions on issuing additional debentures.
- This restriction helps maintain the integrity of the issuer's debt structure and prevents overleveraging.
- Negative Pledge Clause:
- In cases where there is no existing secured debt, a negative pledge clause may be included in the debenture agreement.
- This clause stipulates that if the company issues secured bonds in the future, the debentures will be secured equally with the newly issued secured bonds.
- Essentially, it ensures that debenture holders are not disadvantaged if the issuer decides to secure future debt.
- These provisions provide a degree of protection for debenture holders, helping to mitigate some of the risks associated with investing in unsecured debt.
- Subordinated debenture bonds:
- Subordinated debenture bonds:
- Low Ranking in Default:
- Subordinated debenture bonds have a claim that is at the bottom of the list of creditors if the issuer goes into default.
- If a company defaults, subordinated debenture holders are only paid after all senior debt holders (including other unsecured bonds with higher claims) are satisfied.
- This makes them riskier for investors.
- Unsecured and Higher Interest:
- Since they are unsecured by any collateral and have another unsecured bond with a higher claim above them.
- This means that the issuer has to offer a higher interest rate on the subordinated debentures as compensation for the additional risk.
- Guaranteed Bonds:
- Guarantor's Backing:
- These bonds come with a guarantee from another entity, often a parent company or a stronger financial institution.
- This promises to fulfill the debt obligation if the original issuer fails.
- Not Risk-Free:
- The guarantee itself isn't a guarantee of eliminating default risk.
- The issuing entity's ability to meet the obligation ultimately depends on the guarantor's financial health.
- Correlation Impact:
- The value of the guarantee is influenced by the correlation between the issuer's and guarantor's profitability.
- A negative correlation (where one goes up as the other goes down) strengthens the guarantee's value. Conversely, a positive correlation weakens it.
- Analogy:
- Subordinated Debenture Bonds: Imagine you're a lender and give out small personal loans to friends. A subordinated debenture bond would be like loaning money to a friend with a shaky credit history. You charge a higher interest rate to compensate for the higher risk of not getting repaid.
- Guaranteed Bonds: It would be like your friend's parent guaranteeing the loan. This adds some security, but only if the parent has good financial standing. If both your friend and friend's parent lose your jobs (positively correlated), the guarantee becomes less valuable.
- Overall, subordinated debenture bonds and guaranteed bonds offer different risk-return profiles for investors. Subordinated debentures provide higher returns but come with significant default risk. Guaranteed bonds can offer some comfort, but the guarantor's creditworthiness is a crucial factor.
Methods for Retiring Bonds
- Bond indentures often outline various methods for retiring debt, each serving different purposes and offering different mechanisms for repayment.
- Some are included in the bond’s indenture while others are not included.
- The indenture would not include fixed-spread tender offers.
- The indenture would include the call provisions, sinking funds, maintenance and replacement funds, and redemption through sale of assets.
- Call Provisions:
- Call provisions allow the issuer right to buy back (redeem) the bonds before their maturity date, typically at a predetermined price (often face value) known as the call fixed price either in whole or in part.
- This gives issuers flexibility in managing their debt obligations based on prevailing market conditions. Especially if interest rates have fallen since the bonds were issued, as they can refinance the debt at a lower cost.
- Benefits for Issuers:
- Reduce Interest Costs:
- Call provisions allow companies to call back high-coupon debt and reissue new debt with a lower coupon rate if interest rates fall.
- This saves the company money on interest payments ultimately increasing shareholder value.
- Improve Financial Flexibility:
- Call provisions offer flexibility by allowing the issuer to adjust their debt structure based on market conditions.
- They can react to falling interest rates or changing financial needs by calling back existing debt.
- Alter Capital Structure (Indirectly):
- While not directly changing the capital structure, calling back debt allows the issuer to potentially reissue new debt with different terms, which can indirectly affect the debt-to-equity ratio.
- Eliminate Restrictive Covenants (Limited Impact):
- When a company issues bonds or takes out loans, lenders often impose restrictions known as restrictive covenants.
- These covenants outline certain actions the company can or cannot take, aiming to protect the lender's interests.
- However, there are instances where a company might want to eliminate these restrictions, as they could limit its flexibility in conducting business.
- One way to potentially eliminate these restrictive covenants is through call provisions, which are clauses in bond contracts that allow the issuer to redeem or "call back" the bonds before their maturity date.
- Sometimes, call provisions might be structured to trigger the removal of specific restrictive covenants upon exercising the call option.
- However, this isn't always the case. It's important to note that while call provisions can provide an opportunity to eliminate restrictive covenants, it's not a guaranteed outcome.
- Additionally, restrictive covenants are more commonly associated with loan agreements rather than bond contracts.
- So, even if call provisions are exercised, it may not necessarily result in the removal of these restrictions, especially if they are tied to loan agreements rather than bonds.
- Call Provision Types:
- Fixed-Price Call:
- A fixed-price call provision is a type of call provision found in bond contracts that allows the issuer to redeem the bonds at a predetermined specific prices that can vary over the life of the bonds, regardless of prevailing market conditions.
- This price is predetermined and does not change, hence the term "fixed-price."
- The fixed price at which the bonds can be called back is usually set at a premium to the bond's face value. This premium compensates bondholders for the early redemption of their bonds.
- Fixed-price call provisions offer issuers flexibility and control over their debt obligations.
- They allow issuers to redeem bonds if it becomes advantageous for them to do so, such as when interest rates decline or if they want to eliminate debt ahead of schedule.
- For bondholders, fixed-price call provisions introduce a degree of uncertainty, as they may have to reinvest the proceeds from the redeemed bonds at potentially lower interest rates.
- Variable call prices: The call price, typically starting high and declining towards the face value (par value), is specified in the bond indenture, a legal document outlining the terms of the bond issuance.
- Call protection period: Most bonds do have a call protection period in the initial years, preventing the issuer from calling them back right away. This protects investors from early redemption and ensures they receive the promised interest payments for a certain timeframe.
- Overall, fixed-price call provisions are a tool used by bond issuers to manage their debt effectively, providing them with the option to retire bonds early under specific conditions.
- Make-Whole Call:
- A "make-whole call" provision is a type of call provision found in some bond contracts. Unlike traditional fixed-price call provisions where the redemption price remains constant, a make-whole call provision calculates the call price based on current market conditions.
- Determining the Call Price: The call price under a make-whole call provision is calculated as the present value of the bond's remaining cash flows. This means taking into account all future coupon payments and the bond's principal repayment. The present value is calculated using a discount rate based on the yield of comparable-maturity Treasury securities, commonly referred to as the Treasury yield.
- Floor Price: The call price cannot fall below a certain threshold, known as the floor price. In this case, the floor price is set equal to the bond's par value. This ensures that bondholders will receive at least the par value of their bonds if the issuer decides to call them back.
- Discount Rate: The discount rate used to calculate the present value typically consists of the yield of comparable-maturity Treasury securities plus a premium. This premium accounts for additional risk factors associated with the bond, such as credit risk or liquidity risk.
- Market Rates: Since the call price is determined based on current market rates, it can fluctuate over time as interest rates change. If market interest rates rise, the present value of the bond's future cash flows decreases, resulting in a higher call price. Conversely, if market interest rates fall, the present value increases, leading to a lower call price.
- Purpose: The purpose of a make-whole call provision is to compensate bondholders for the early redemption of their bonds by ensuring that they receive fair value based on prevailing market rates. By using a make-whole call provision, issuers can redeem bonds early without unduly disadvantaging bondholders.
- Conversion or Convertible Bonds:
- An alternate form for bond retirement is to allow the bonds to be converted to common shares at a predetermined rate.
- Conversion Option: This refers to a feature in some bonds that allows bondholders to convert their bonds into a predetermined number of common shares of the issuing company. For example, a bond may offer the option to convert each $1,000 bond into 100 shares of common stock.
- Potential Benefit to the Issuer (Call Option): The call option benefits the issuer because it allows them to retire the bonds early if it becomes advantageous for them to do so, such as if interest rates decrease or if they want to eliminate debt ahead of schedule.
- Potential Benefit to the Investor (Conversion Option): The conversion option benefits the investor because it provides the opportunity to convert bonds into common shares if the stock price rises above a certain level, potentially allowing them to participate in any increase in the value of the company's stock.
- The fact that a call option (potential benefit to the issuer) is often combined with the conversion option (potential benefit to investor) may incentivize the investor to exercise the conversion option earlier (e.g., before the stock price has risen too much).
- Incentive for Early Conversion: When a bond offers both a call option and a conversion option, it creates an incentive for bondholders to exercise the conversion option earlier, especially if they believe the stock price will rise further. This is because if the issuer sees a significant increase in the stock price, they may be more likely to call the bonds to avoid issuing shares at a lower predetermined price through conversion.
- Issuer's Perspective: From the issuer's perspective, if the stock price rises significantly, it may become more expensive for them to issue shares through conversion than to call the bonds at the predetermined call price. In such a scenario, the issuer is more likely to call the bonds to avoid the potential dilution of issuing shares at a relatively low predetermined price.
- Sinking Funds:
- Sinking funds require the issuer to set aside a portion of funds regularly to retire the bond principal gradually.
- This ensures that funds are available for repayment at maturity and can provide investors with greater confidence in the issuer's ability to meet its obligations.
- The bonds can either be retired by use of a lottery where the owners of the selected bonds must redeem them, or the bonds are purchased in the open market.
- Bond call lottery:
- This method involves randomly selecting a certain number of bonds for repurchase. Bondholders whose bonds are chosen are obligated to sell them back to the company at the call price.
- For bondholders: If your bond gets picked in the lottery, you must sell it back to the company at the predetermined call price (usually the face value).
- For the company: This method is advantageous because it ensures a specific number of bonds are retired. It can be a good option if they have a limited amount of money available for buybacks.
- Open market repurchase:
- Here, the company goes into the open market and buys back its own bonds from willing sellers.
- The price is negotiated and may be at a premium depending on market conditions. Think of it as the company going shopping for its own bonds in the open market.
- This method offers more flexibility than a lottery but can be more expensive depending on market conditions.
- A sinking fund can be used to fund either a bond call lottery or open market repurchases, depending on the terms of the bond issuance. The issuer decides how they will use the accumulated funds to retire the bonds.
- Bond call lotteries and open market repurchases are specific methods for executing a call provision on a bond. A sinking fund doesn't directly trigger a call provision, but it provides the financial resources to do so.
- Sinking-fund provisions also make sense when the value of the collateral goes down with time; therefore, the provisions would reduce the borrowings at the same time. Alternatively, if it is desired not to reduce the borrowing levels, then additional collateral can be provided to offset the potential decline in the value of existing collateral.
- Sinking-Fund Provisions and Collateral Value: Imagine a scenario where a company has issued bonds backed by collateral, such as real estate or other assets. Over time, the value of this collateral may decrease due to various factors like depreciation, market fluctuations, or wear and tear.
- Reducing Borrowings: When the value of the collateral decreases, it affects the overall financial position of the company. Sinking-fund provisions come into play here as they provide a structured way for the company to retire or pay off a portion of its debt each year. By using the sinking fund to buy back some bonds, the company effectively reduces its borrowings.
- Offsetting Decline in Collateral Value: However, if the company wishes to maintain its borrowing levels steady despite the declining collateral value, it has another option. Instead of reducing the debt through the sinking fund, the company can provide additional collateral to compensate for the potential decline in the value of existing collateral.
- Maintaining Financial Stability: By either reducing borrowings through the sinking fund or providing additional collateral, the company aims to maintain a stable financial position. This ensures that it meets its obligations to bondholders while also managing any risks associated with the changing value of collateral.
- Maintenance and Replacement Funds:
- Maintenance and replacement funds are similar to sinking funds but are specifically designated for the maintenance or replacement of certain assets that serve as collateral for the bonds.
- This helps ensure that the collateral remains in good condition, thereby protecting the interests of bondholders.
- The key differences between sinking funds and maintenance and replacement fund provisions.
- Sinking Funds:
- Simpler: Generally, sinking funds involve setting aside money periodically to eventually retire debt. The valuation of underlying assets isn't a direct concern.
- Maintenance and Replacement Fund Provisions:
- More Complex: These provisions require a more proactive approach. The fund must be sufficient to maintain the value of the underlying assets, which often necessitates valuation formulas.
- Analogy:
- Home Mortgage: Just like a homeowner needs to maintain their property value, a maintenance and replacement fund ensures the underlying assets used to secure debt (like equipment or buildings) don't depreciate excessively.
- Fulfilling the Provision:
- There are two ways mentioned to satisfy the provision:
- Cash Acquisition: The company can accumulate enough cash within the fund to maintain the overall financial health of the firm. This cash can then be used strategically, like retiring debt, which can improve the company's financial standing.
- Collateral Sale: The company can sell some of the collateral associated with the debt. However, the proceeds from this sale must typically be used to retire the bonds early, fulfilling the purpose of the maintenance and replacement fund.
- Sinking funds and maintenance and replacement funds serve similar goals (debt management), but they differ in complexity and approach. Sinking funds are simpler, focusing on periodic contributions for debt repayment. Maintenance and replacement funds require ongoing efforts to ensure the value of underlying assets is maintained.
- Redemption Through Sale of Assets:
- Some bond indentures may allow for the redemption of bonds through the sale of specific assets.
- This can be particularly relevant for asset-backed securities, where the proceeds from the sale of underlying assets are used to repay bondholders.
- Tender Offers:
- Tender offers are usually a means for retiring debt for most firms.
- The firm openly indicates an interest in buying back a certain dollar amount of bonds or, more often, all of the bonds at a set price.
- Firms can also announce that they will buy back bonds at an amount calculated as the present value of future cash lows based on a speciic discount rate (e.g., the yield to maturity on a comparable-maturity Treasury plus a spread).
- Fixed-spread tender offers involve the issuer making a tender offer to repurchase bonds at a predetermined spread above a benchmark, such as a government bond yield.
- This method is not typically included in the bond indenture and is instead executed through separate tender offer documents.
- While call provisions, sinking funds, maintenance and replacement funds, and redemption through asset sales are commonly included in bond indentures to manage debt repayment, fixed-spread tender offers are usually executed through separate procedures outside of the indenture.
- Each method offers issuers and investors different avenues for retiring debt and managing bond obligations.
Credit Risk
- Credit risk includes credit default risk and credit spread risk.
- Credit default risk
- Credit default risk is the uncertainty concerning the issuer’s making timely payments of interest and principal as prescribed by the bond’s indenture.
- The most widely used indicators of this risk are bond ratings that major rating agencies assign when those agencies perform credit analysis of a firm.
- Bond ratings act like credit scores for bonds, assigned by major rating agencies to assess the creditworthiness of a bond issuer (company or government) and the risk of them defaulting on their debt.
- Fitch Ratings, Moody’s, and Standard & Poor’s are the main rating agencies in the United States.
- The agencies assign a symbol associated with the rating (e.g., AAA or Aaa for the corporate debt with the least credit default risk).
- The rating can be interpreted as a probability of default within some time period, as well as the probability of a change in a rating within some time period.
- Credit spread risk
- Credit spread risk focuses on the difference between a corporate bond’s yield and a yield of risk-free bond (usually government bonds like Treasuries). It reflects the additional risk investors demand for holding a riskier asset (corporate bond) compared to a safe haven (government bond).
- This difference is known as the credit spread.
- It should be noted that other factors such as embedded options and liquidity factors can affect this spread; therefore, it is not only a function of credit risk.
- Credit spread risk increases when the economy deteriorates (e.g., moves through the business cycle).
- When the economy weakens, investors generally become more risk-averse.
- They seek the safety of government bonds, which are perceived as having a very low chance of default.
- This increased demand for Treasuries drives their prices up, pushing their yields down.
- In contrast, corporate bonds become less attractive during economic downturns.
- Investors perceive a higher risk of default by companies due to factors like:
- Lower profits
- Increased difficulty repaying debt
- Potential for bankruptcies
- To compensate for this higher perceived risk, investors demand a higher yield on corporate bonds.
- This means the price of corporate bonds falls (as yield and price have an inverse relationship) to reflect the increased risk premium.
- As government bond yields go down and corporate bond yields go up, the credit spread widens. This widening reflects the increased risk premium investors demand for holding corporate bonds in a weak economy.
- A method commonly used to evaluate credit spread risk is spread duration. The duration of the spread is the approximate percentage change in a bond’s price for a 100- basis-point change in the credit spread assuming that the Treasury rate is constant. If a bond has a spread duration of 4, for example, a 50-basis-point change in the spread will change the value of the bond by 2%.
- Spread duration
- It's a measurement that estimates the sensitivity of a bond's price to changes in the credit spread. It tells you how much a bond's price is likely to change (as a percentage) for a given change in the difference between a corporate bond's yield and a government bond's yield (credit spread).
- Units and Interpretation:
- Spread duration is typically expressed in years.
- A higher spread duration indicates a greater sensitivity of the bond's price to changes in the credit spread.
- Conversely, a lower spread duration indicates a lesser sensitivity of the price to credit spread fluctuations.
- The Example:
- Spread Duration of 4: This means the bond's price is expected to change by approximately 4% for every 1% change in the credit spread (assuming government bond yields remain constant).
- 50 Basis Point Change: A 50 basis point change is equivalent to 0.5% (50 divided by 100).
- 2% Price Change: Given the spread duration of 4, a 0.5% widening of the credit spread would translate to an estimated 2% decrease in the bond's price (4 multiplied by 0.5).
- Why is Spread Duration Important?
- It helps investors understand how their bond portfolio might react to changes in the credit market. Bonds with higher spread durations are more volatile and can experience larger price swings when the credit spread widens or narrows.
- Investors can use spread duration to manage their portfolio's risk profile. By choosing bonds with varying spread durations, they can achieve a balance between potential returns and risk exposure to credit spread fluctuations.
- Limitations of Spread Duration:
- It assumes a parallel shift in the yield curve, meaning government bond yields remain constant. In reality, the yield curve can also change shape, impacting bond prices.
- It doesn't account for other factors that can affect bond prices, such as changes in call provisions or embedded options.
Event Risk
- Event risk addresses the adverse consequences from possible events involving signiicant increases in leverage, such as mergers, recapitalizations, restructurings, acquisitions, leveraged buyouts, and share repurchases, which may escape being included in the indenture.
- Such events can drastically change the irm’s capital structure and reduce the creditworthiness of the bonds and their value.
- In order to protect bondholders, a company may include in the indenture a maintenance of net worth clause that can require the company to maintain a minimum equity level.
- If that level is breached, then it must repurchase a suficient amount of its debt at par value to reach the minimum equity level.
High Yield Bonds
- High-yield bonds (a.k.a. junk bonds) are those bonds rated below investment grade by ratings agencies.
- This includes a broad range of ratings below the cutoff, (e.g., Ba1/BB+ down to default).
- Over long periods of time, high-yield bonds should offer higher average returns.
- However, over shorter periods, the returns will be volatile where large losses are possible.
- Types of high-yield bonds:
- Rising stars: These are bonds issued by companies with strong growth prospects but that are not yet considered investment-grade due to their limited track record. Companies who issue bonds with a non-investment-grade rating. Such issuers include the below:
- Young and growing companies: would not have strong financial statements but have promising prospects.
- Companies with consistent cash flows: These companies may have a solid track record of generating cash flow, but their credit rating might not be investment-grade due to other factors. For example, they might have a high debt burden from previous acquisitions or expansion plans. By issuing high-yield bonds, they can access capital at a lower cost than issuing new equity (stocks). However, the interest payments on these bonds are higher compared to investment-grade bonds.
- Fallen angels: These are bonds that were originally issued by investment-grade companies but have since been downgraded to high-yield status due to a deterioration in the issuer's creditworthiness.
- Cyclicals: These are bonds issued by companies in industries that are sensitive to economic cycles. The value of these bonds can fluctuate significantly depending on the state of the economy.
- Distressed bonds: These are bonds issued by companies that are in financial trouble and may be at risk of default. These bonds offer the highest potential returns but also carry the highest risk.
- Emerging market bonds: These are bonds issued by companies in developing countries. These bonds can offer higher yields than developed market high-yield bonds, but they also carry additional risks, such as political instability and currency fluctuations.
- Types of coupon structures:
- Deferred-coupon bonds, which would sell at a discount and not pay any interest for an initial period and then pay the stated coupon afterward.
- Step-up bonds, pay a low coupon in the early years and then a higher coupon in later years.
- Payment-in-kind bonds, allow the issuer to pay interest in the form of additional bonds over the initial period.
- Extendable reset bonds, allow the issuer to reset the coupon as frequently as needed to keep the bond price at a specified level. This means they can adjust the interest rate paid to bondholders to ensure that the bond's price remains close to a specified level, often its par value. The purpose of this feature is to help maintain the stability of the bond's price. If the bond's price starts to deviate significantly from its specified level, the issuer can reset the coupon rate to bring it back in line. For investors, extendable reset bonds offer a degree of stability in terms of the bond's price, as the issuer can adjust the coupon rate to prevent large fluctuations. However, they may also introduce uncertainty about future interest payments, as the coupon rate can change over time.
Default Rate
- A default occurs if there are any missed or delayed disbursements of interest and/or principal.
- It has been proven that lower credit ratings indicate a higher probability of default, but there are two ways to measure default:
- by the raw number of issuers that defaulted
- by the dollar amount of issues that defaulted
- For each approach in measuring default rates, there are different formulas, which can lead to researchers reporting different default rates for the same data set.
- Issuer default rate
- Formula:
- number of issuers that defaulted over a year / the total number of issuers at the beginning of the year.
- It is only a proportion of the number of issuers who do fulill their obligations and does not include a measure of the dollar amount involved.
- Dollar default rate
- The dollar default rate is the par value of all bonds that defaulted in a given calendar year divided by the total par value of all bonds outstanding during the year.
- Formula:
- Over a multiyear period, often-used measures are ratios of cumulative dollar value of all defaulted bonds divided by some weighted-average measure of all bonds issued. One such measure attempts to weight the bonds outstanding by the number of years they are in the market:
- Formula:
Recovery Rate
- The recovery rate is a crucial concept in bond investing, representing the amount investors receive as a proportion of the total obligation after a bond defaults.
- Definition of Recovery Rate:
- After a bond defaults, investors may not receive the full amount owed to them by the issuer.
- The recovery rate quantifies how much of the defaulted bond's value investors are able to recover.
- It's typically expressed as a percentage of the bond's face value or the total amount owed.
- Complexity of Measurement:
- Determining the recovery rate can be complex for several reasons.
- Firstly, it involves calculating the present value of the remaining cash flows from the bond at the time of default.
- This requires estimating the future cash flows of the bond and discounting them back to their present value, taking into account factors like the timing and probability of receiving these cash flows.
- Form of Recovery:
- Additionally, the recovery amount may not always be in the form of cash.
- Sometimes, investors may receive securities or assets, such as stock in the defaulting company, as part of the recovery process.
- This adds another layer of complexity to measuring the recovery rate, as the value of these securities needs to be accounted for.
- Moody's Study Findings:
- A study by Moody's, a leading credit rating agency, estimated that the average recovery rate for defaulted bonds has been around 38%.
- This means that investors typically recover about 38% of the total obligation owed to them after a bond defaults.
- It's important to note that this is an average figure and actual recovery rates can vary widely depending on various factors.
- Impact of Seniority:
- Bonds with higher seniority in the capital structure of a company, such as senior secured bonds, typically have higher recovery rates.
- This is because these bonds have priority claims on the company's assets in the event of default, making them more likely to receive a larger portion of the recovery amount compared to junior or subordinated bonds.
- In summary, the recovery rate represents the percentage of the total obligation investors are able to recover after a bond defaults. Measuring the recovery rate involves considering factors such as the form of recovery, the present value of remaining cash flows, and the impact of bond seniority.
Expected Return
- Earnnings from the bond.
- A bond’s expected return is calculated as:
- risk-free rate + credit spread − expected loss rate
- risk-free rate: provides the baseline return.
- credit spread: credit spread is the difference in yield or interest rate between a bond with credit risk and a risk-free investment, typically a government bond.
- It represents the additional compensation that investors demand for bearing the risk of default associated with the bond issuer.
- In other words, it's the premium investors require for taking on the credit risk of holding the bond.
- Compensation for risk:
- When investors purchase bonds, they expect to be compensated for the risks they are taking.
- Credit risk is one of these risks.
- The credit spread compensates investors for the additional risk of holding a bond compared to a risk-free investment like a government bond.
- Expected Loss Rate:
- The expected loss rate represents the anticipated loss due to default risk.
- It takes into account the probability of default and the potential loss severity in the event of default.
- This rate is typically estimated based on historical default data, issuer credit ratings, and other relevant factors.
- Relationship between Credit Spread and Expected Loss Rate:
- When the credit quality of the issuer is higher (meaning the issuer is considered less likely to default), investors perceive less risk associated with holding the bond.
- Therefore, they may demand a smaller credit spread as compensation for this lower risk.
- Conversely, when the credit quality of the issuer is lower (indicating a higher likelihood of default), investors perceive greater risk and may require a higher credit spread to compensate for this increased risk.
- Study Findings:
- The study notes that the excess of the credit spread over the expected loss rate tends to be lower (or higher) when the credit quality of the issuer is higher (or lower).
- This observation aligns with the general principle that investors adjust their required compensation (credit spread) based on their assessment of the issuer's credit risk and the expected loss rate associated with holding the bond.
- expected loss rate: adjusts for the potential loss due to default risk.
- expected loss rate here is equal to: probability of default × (1 − expected recovery rate).
- The Treasury rate is a widely used benchmark, but it's not always the most appropriate risk-free rate for corporate bonds and a higher rate such as the interbank borrowing rate may be appropriate.
- Limitations of Treasury Rate for Corporate Bonds:
- While the Treasury rate is a good benchmark for government bonds, it might not be entirely suitable for corporate bonds for a few reasons:
- Default Risk: Corporate bonds carry default risk, meaning there's a chance the issuer (company) may not be able to repay the loan. Treasury bonds, on the other hand, are considered risk-free.
- Liquidity: Treasury bonds are generally highly liquid, meaning they can be easily bought and sold in the market. Corporate bonds, especially those issued by smaller companies, may be less liquid.
- Interbank Borrowing Rate:
- The interbank borrowing rate, such as the London Interbank Offered Rate (LIBOR) or the Overnight Indexed Swap (OIS) rate, reflects the interest rate at which banks lend to each other in the interbank market.
- This rate is typically higher than the Treasury rate and is influenced by various factors, including credit risk and liquidity risk.
- Appropriateness for Corporate Bonds:
- Using a higher rate like the interbank borrowing rate as the risk-free rate for corporate bonds may be more appropriate because it better reflects the additional risk inherent in these bonds.
- Since the interbank borrowing rate incorporates credit risk premiums, it provides a more accurate measure of the opportunity cost of investing in corporate bonds compared to investing in risk-free assets.
- Market-Based Approach:
- Some argue that using market-based rates such as interbank borrowing rates aligns better with the principle of opportunity cost, as it reflects the rates at which investors can earn a return in the market adjusted for risk.
- This approach acknowledges that investors require a higher return for bearing credit risk when investing in corporate bonds compared to risk-free assets.
- Regardless of the risk-free measure, in calculating expected return, investors in corporate bonds expect to earn more than the risk-free rate.
Credits and References
https://www.fisdom.com/wp-content/uploads/2021/07/39-1.jpg
https://gemini.google.com/
https://chat.openai.com/
SchweserNotes and BionicTurtle Notes
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