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Money & Banking ­ MGT411
VU
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
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
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Money & Banking ­ MGT411
VU
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
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.
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Money & Banking ­ MGT411
VU
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.
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Money & Banking ­ MGT411
VU
Figure: The effect of an increase in risk on equilibrium in the bond market
S
Increased risk reduces the demand for
the bond at every price, shifting the
demand curve to the left from Do to
Po
Eo
D1. The result is a decline in the
equilibrium price and quantity in the
P1
E1
market. Importantly, the price falls
from Po to P1, so the yield on the
bond must rise.
Do
D1
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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Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY