BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings

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Money & Banking MGT411

Lesson 16

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

0.10

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

Money & Banking MGT411

Probabilities

Inflation

Case I

Case II

Case III

0.50

0.25

0.10

0.50

0.80

0.50

0.25

0.10

Expected Inflation

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

long-term 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.

Money & Banking MGT411

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

Slightly less likely to pay principal + interest

Strong capacity to make payments, upper medium grades

BBB

Baa

Medium grade, adequate capacity to make payments

Moderate ability to pay, speculative element, vulnerable

Not desirable investment, long term payment doubtful

CCC

Caa

Poor standing, known vulnerabilities, doubtful payment

Highly speculative, high default likelihood, known reasons

Lowest rated class, most unlikely to reach investment grades

Already defaulted on payments

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.

Money & Banking MGT411

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

Increased risk reduces the demand for

the bond at every price, shifting the

demand curve to the left from Do to

D1. The result is a decline in the

equilibrium price and quantity in the

market. Importantly, the price falls

from Po to P1, so the yield on the

bond must rise.

Quantity of Bonds

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 risk-

free) 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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