By Nicholas Gliagias and Rom Badilla, CFA
One of the most significant risks for bond investors to consider is credit risk. Credit risk, also known as default risk, is the risk that a bond issuer will default on their payments of interest and principal. When a bond issuer defaults on their payments, the holders of the bond may lose most of their principal. For the most part, bonds issued by the federal government are immune from default and therefore have no credit risk. However, bonds that are issued by corporations are much more likely to be defaulted on, since companies can go bankrupt. Therefore, credit risk is a very important factor to consider when investing in corporate bonds.
Corporate bonds tend to offer higher yields compared to other investments to compensate the bond investor for the credit risk. Corporations that issue high yield bonds can be small companies or even large companies that are experiencing a degree of financial distress. As high yield bonds are generally more risky than investment-grade bonds, investors expect to earn a higher yield to compensate them for that risk. In order to lessen the impact of the default risk, the buyers of the bond will demand yields that correspond to the issuer's level of default risk. In other words, usually when the risk of default for a bond becomes higher, the yield of the bond will also grow.
A good measure to assess the default risk of a bond is its credit rating. Credit ratings are given out by rating agencies such as Moody's and Standard & Poor's Corporation. Bonds that are seen as less likely to default are given higher ratings which are usually accompanied by lower yields, while bonds that are more likely to default are given lower ratings, usually accompanied by higher yields. In other words, high-yield corporate bonds can carry a lot of credit risk. High-yield bonds that are poorly rated may also be called junk bonds.
When a bond issuer defaults on their payments, the bondholder may lose their principal. However, a bond issuer does not have to default for credit risk to affect investors. If one or more credit rating agency downgrades a bond issue, or the market has a perception this may happen, the price of a bond will drop. The rating agencies will change their ratings for many different reasons including a change in the bond issuer's industry, the financial and competitive standing of the issuer, and anything that will impact the issuer's ability to meet the financial obligation to bondholders including their ability to pay off their debt.
Positive changes can result in an issuer's ratings being upgraded. Many bond traders speculate by buying bonds of issuers that they think may be on the verge of a ratings upgrade. A ratings downgrade does not necessarily mean an issuer is close to default, and a change of one level may not necessarily result in a significant price change for highly rated issuers. However, bondholders should view a downgrade as a warning sign and carefully monitor the company for possible further deterioration.
A downgrade that reduces an investment grade bond to non-investment grade can be particularly problematic. Many institutional investors are required to hold only investment grade bonds. If a bond that these institutions hold is no longer investment grade, they will be forced to sell that bond. Because of the large positions these institutions usually hold, this selling can cause significant downside pressure on the bond's price. In addition, a rating downgrade of more than one level can have a significant impact on the bond's price.
Another way to assess the credit risk of a bond is through the use of financial ratios. Some widely used metrics are the interest coverage ratio and capitalization ratios. The interest coverage-ratio is used to find how much money the company generates each year in order to fund the annual interest on its debt. The formula for this ratio is EBIT, or earnings before interest and taxes, divided by the annual interest expense. The higher the interest coverage ratio, the better the position of the company to pay off the interest on its debt. An interest coverage ratio below 1.0 indicates that the company is not generating sufficient revenues to satisfy interest expenses.
The capitalization ratio assesses the company's degree of financial leverage. It is used to find how much interest-bearing debt the company carries in relation to the value of its assets. The formula for this ratio is long-term debt divided by long-term debt plus shareholder's equity. The lower the capitalization ratio, the better the company's financial leverage.
Finally, the future economic outlook of a company is very important to take into account while considering the credit risk of a corporate bond. This is because bonds are a function of time due to the fixed coupon payment given to the bond investor every period for the entire maturity of the bond. Although high yielding bonds with a high coupon rate may look very attractive at first glance, ultimately they may not give you the high yield you desire if the coupon payments are cut short because of an early default. A corporation that is financially unstable is much more likely to default on their coupon payments. Even before this happens a rating agency may downgrade the bond, possibly resulting in a substantial decrease in its price.
However, high-yield bonds do have some advantages. High-yield bonds do not correlate exactly with either investment-grade bonds or stocks. Since their yields are typically higher than investment-grade bonds, they may be less vulnerable to interest rate shifts, especially at lower levels of credit quality, and are similar to stocks in relying on economic strength. Due to this low correlation, adding high-yield bonds to your portfolio can be a good way to reduce overall portfolio risk when considered within the classic framework of diversification and asset allocation.
It is also important to note that should the bond issuer go bankrupt, the bond holders have an advantage as they will be paid first during the liquidation process, followed by preferred stockholders, and lastly common stockholders. This feature can prove valuable in protecting a bondholder's overall portfolio from significant losses.
Overall, higher-quality bonds tend to perform better than lower-quality bonds even during times of economic distress. This is because issuers of higher-quality bonds have sufficient financial strength to keep making their payments even under unfavorable conditions. However, the same cannot be said for lower-rated issuers, who may default on their payments.
In conclusion, investors of corporate bonds should know how to assess credit risk and its potential payoffs. Companies that issue high yield bonds entice the investor with this high yield, but at the end of the day it is important to remember that there can still be a lot of credit risk to account for. In addition, looking at credit ratings and financial ratios of different corporations can give us a glimpse of a company's financial stability and credit worthiness. Although there are many other risks to consider, understanding credit risk and how it can affect the value of your bond is a significant step that should be taken before investing.