In this section, we will discuss credit risk, interest rate risk and liquidity risk, which affect the YTM of a bond. We will focus mostly on credit risk because it is the main driver of yield for HY bonds (Torgersen, 2016).
8 Variations of this equation will be showed in other sections. While the equations will be presented with minor differences, they are derived from the same concepts.
Figure 2: Market Interest Rate/ Market Yield
Market Interest Rate/ YTM
Credit Risk Interest Risk Liquidity Risk
Interest Rate Expectations
=
Source: Own illustration and Valset (2003).9
Credit Risk
Credit risk is the risk that the issuer may not be able to service all or some of the promised obligations due to financial distress, restructuring10 or bankruptcy, i.e. default on the payment obligations set out in the bond agreement. Corporate bonds are divided into two classes based on perceived credit/default risk: IG and HY (Sundaresan, 2009). Default is defined by credit rating agency Moody’s in three alternative ways (Moody’s, 2007)11:
1. A missed or delayed disbursement of interest and/or principal, including delayed payments made within a grace period. 12
2. Bankruptcy, administration, legal receivership, or other legal blocks (perhaps by regulators) to the timely payment of interest and/or principal.
3. A distressed exchange occurs where:
a. the issuer offers debt holders a new security or package of securities that amount to a diminished financial obligation (such as preferred or common stock, or debt with a lower coupon or par amount, lower seniority, or longer maturity); or
b. the exchange had the apparent purpose of helping the borrower avoid default.
9The amount that each risk factor contributes to the market interest rate is not scaled in the figure.
10 Restructuring is the process of renegotiating or rewriting financial contracts outside courts and liquidation is the process of restructuring under court supervision (Gilson, 2010).
11The description of default is collected directly from Moody´s FAQ (2016).
12Companies are often given a grace period on interest payments, but if the company does not settle payments within the grace period then it is in default.
Credit Ratings
Credit ratings draw the line between IG and HY bonds, and try to capture the credit risk of a company. Official ratings are set by a credit rating agency, such as Moody’s, S&P and Fitch.
Because the spread over the risk-free rate determines the price of the bond, the achieved credit rating greatly affects the price and availability of funding for the issuer. Ratings can be given to both a company and its different tranches of debt. They are not necessarily the same because the rating agencies evaluate the credit quality of the issuer and the bond’s subordination when they assign ratings (Cederlof and Liedgren, 2015). Credit ratings are based on analysis of common financial and operational ratios. These ratios try to evaluate the profitability, liquidity, solvency and capital structure of a company. An official credit rating is often important to achieve attention from investors because some institutional investors are mandated to only invest in rated securities (Goldstein and Huang, 2015). The importance of official credit ratings is much more apparent in the US; official ratings are not required and rather uncommon in Norwegian HY.
Table 1: Credit Rating System
Source: ABG Sundal Collier (2014)
The credit rating agencies have been under pressure in the aftermath of the subprime crisis due to a perceived conflict of interest which some argue led to incorrect assessments of risks by the credit agencies. To obtain an official rating, firms have to pay the credit rating agencies. Critics argue that the agencies have incentives to be generous with ratings, as their business model requires clients that are willing to pay for it. This trend has been called credit rating inflation since the agencies give the firms too favourable credit ratings (Goldstein and Huang, 2015).
Credit Spread
US government bonds are considered risk-free, in the sense of credit risk, because they are backed by the full faith and credit of the US government. The US government theoretically has the ability to raise taxes or print money in case it is not able to honour its obligations. One way to quantify credit risk is therefore to look at the spread between treasury bonds and corporate bonds with similar time-to-maturity. This spread is known as the credit spread. The riskier a company is the higher its credit spread will be (Sundaresan, 2009).
Figure 3: Hypothetical Yield Curve for IG and HY bonds
Source: Own illustration
Interest Rate Risk
Interest rate risk is the risk that the value of an investment will change due to changes in interest rate levels. Fixed bonds are exposed to interest rate risk, while FRN bonds are exposed to minimal
0%
1%
2%
3%
4%
5%
6%
3M 6M 1Y 2Y 3Y 5Y 10Y
YTM
Time to Maturity
Government Investment Grade High Yield
Credit Spread for IG Bond
Credit Spread for HY Bond
interest rate risk, as they are re-priced every time the reference rate is set.13 As illustrated in Figure 4, there is an inverse relationship between the price of a bond and interest rates. If interest rates fall, the price of fixed bonds will go up because the bond offers an attractive return based on new market interest rates, and this will decrease the YTM. If interest rates increase, the bond, compared to bonds being issued with similar credit risk, will no longer sufficiently compensate the investor. This will decrease prices for fixed bonds because investors will be willing to pay less for the promised cash flows, which will increase the YTM (Sundaresan, 2009).
Figure 4: Bond Prices and Interest Rate Movements
Source: Own illustration
The sensitivity to interest rate changes of a bond can be measured by calculating the modified duration and convexity. Modified duration quantifies how much the price of a bond changes when the yield changes. It is calculated by dividing the Macaulay duration14 by the market price of the bond. Altman (1998) points out that, due to higher coupon rates, the Macaulay duration on HY bonds is lower than that of other types of bonds, i.e. HY bonds should not be as sensitive to interest rate fluctuations because a higher portion of the present value of the cash flows will be received sooner. Convexity measures how much the slope of the price-yield curve changes for a
13 An FRN bond that pays a certain spread over a 3M interbank rate is re-priced every 3 months when the reference rate is set (Sundaresan, 2009).
14 Macaulay Duration is the discounted cash flow weighted average time until all of the cash flows of a bond are received.
small change in yield (Sundaresan, 2009). These concepts are central to bond theory, but not essential to our analysis.15
Liquidity Risk
Liquidity refers to how easy a reasonable amount of a security can be transacted in a market within short notice, without having an adverse effect on the price (Sundaresan, 2009). Aspects that determine the level of liquidity are:
1. Transaction costs (fees and commissions).
2. Bid-ask spreads and volume depth.
3. Market impact costs (price changes).
The liquidity premium is a very common risk factor analysed in academia. According Rakkestad, Skjeltorp and Ødegaard (2012), many bonds in the Norwegian market suffer from low transaction volume, which increases the bid-ask spread. Knappskog and Ytterdal (2015) found that illiquid bonds had a 110 basis points higher spread at issue, which shows that investors require a higher expected rate of return from illiquid bonds. 16
According to Vegard Annweiler (2014), CEO of Nordic Bond Pricing (NBP), the Norwegian HY market is illiquid and non-transparent. In general, the liquidity of bond markets varies among countries. The corporate bond market in the US is considered liquid compared to the Norwegian bond market, nevertheless, only 15% of the outstanding corporate bonds were traded on a daily basis in June 2013 (Sedgwick, 2013). This research shows that trading is limited even in bond markets that are considered liquid.Because the liquidity is low, it is realistic to assume that certain investors buy bonds to hold them until maturity. A reason for doing so could be to match assets and liabilities.