7. Credit risk
How big is the risk?
Credit risk is the risk of a price drop in the bond that is related to the issuer’s creditworthiness. Credit risk is the risk factor that affects the price of an individual corporate bond the most, especially high-yield bonds.
Default occurs when the issuer is unable to meet the obligations of the bond indenture – for example, if it is unable to pay a coupon on time. The issuer then has the choice of either applying for restructuring or for bankruptcy.
Restructuring means that the company is run by a restructurer who works closely with the company’s financiers. The lenders are usually in the driving seat and restructuring can take anywhere from a few weeks to several months. The end result is usually that shareholders inject more equity and that bondholders make some form of write-down of the size of the bond. The restructuring process may also end in failure to reach agreement and the company going bankrupt.
Bankruptcy means that the company’s management is taken over by a liquidator appointed by the district court. The company’s financiers have no control over the process. The liquidator realizes all of the company’s assets and pays out the remaining value on the basis of the order of priority between the financiers.
ORDER OF PRIORITY (STATUS)
In the event of bankruptcy, the liquidator pays out the remaining recovery value on the basis of the order of priority between the financiers. Shareholders
and preference shareholders have the lowest priority and little chance of receiving repayment. The bank usually has top priority and a chance of full repayment. The bondholders come in between with their specific priorities (see diagram on the right).
The default probability is related to the issuer’s creditworthiness and the maturity of the bond.
There is greater risk of default for an issuer with a lower creditworthiness; there is also a greater risk of default in the long term than in the short term.
Rating agencies have been collecting historical default statistics for many decades. The table on the next page shows how the default probability differs between rating categories and maturity.
The value that remains for bondholders in the event of default is called the recovery value. Historical statistics show that the average recovery value varies depending on the priority and collateral the bond has. Recovery rate is the ratio between recovery value and the par value of the bond and is often expressed as a percentage. Recovery rate is defined as the value of the bond one month after default (see example on next page), which is usually a low for the bond’s value. As an investor, it is possible to choose to hold on to the bond and, in the event of successful restructuring, the bond price may exceed the recovery rate by a considerable amount.
Using the historical default probability and recovery rate, it is possible to calculate the expected loss for a corporate bond. A bond’s expected loss is its default probability multiplied by the value lost at default – that is, one (1) minus the recovery rate. It is easy to think that the default probability is the expected loss. In reality, it is less because in the vast majority of cases corporate bonds have a positive recovery value.
Actuarial spread is the spread needed to cover the bond’s expected loss. In most cases credit spread is greater than actuarial spread.
The spread premium is the credit spread minus the spread needed to cover the historical expected loss (actuarial spread). It shows how much additional compensation you receive for holding a corporate bond and can be divided into several components (see diagram to the right). It is difficult to know how large the different components are in relation to each other so the term spread premium is often used.
The price of a corporate bond rises or falls when the credit spread or government base rate changes. Duration is an effective measure of how much the price changes. A bond with a long maturity (higher duration) is more sensitive to changes in credit spread and government base rates (see graph on the right). Duration can be calculated in several ways but the most useful measure is modified duration. Modified duration expresses price sensitivity as a percentage.
A modified duration of 3 means that if the interest rate or credit spread increases by one percentage point, the bond price will fall by 3%, and vice versa. A 5-year bond without coupons has a modified duration of 5, while a 5-year bond with a 6% coupon has a duration of 4.2. Modified duration can also be used at portfolio level.
PRINCIPLES OF DURATION
- Duration increases as the bond’s maturity increases. With a longer maturity, price sensitivity is higher.
- Duration decreases with larger coupons. With a higher coupon, price sensitivity is lower.
- Duration falls as the bond yield increases. With a higher yield, price sensitivity is lower.
The graph above shows the credit spread for US investment-grade bank bonds in 2007-2012. The index contains the largest and strongest banks in the United States, including Morgan Stanley, J.P. Morgan and Citigroup. Prior to the financial crisis, they traded with a credit spread of 0.8 percentage points. When the crisis was at its worst, the credit spread was 7 percentage points. As the bonds had a relatively long maturity, the index was down a full 25% over the period.
Relationship between price and yield for bonds with different maturities (coupon 5%)
Bonds with a floating (variable) coupon are common in the Nordic region. The bonds are not very sensitive to changes in government base rates. The coupon comprises a fixed credit spread tied to a short-term interest rate. The short-term interest rate is usually the three-month Stibor if the bond is issued in Swedish kronor. The coupon is usually paid every three months when a new coupon level is also set. The new coupon level is based on the short-term interest rate at the time.
If, as an investor, you think that interest rates are going to go up, a bond with a floating coupon is better than one with a fixed coupon. The advantage of a floating coupon is that the price of the bond moves less when the government base rate rises while at the same time the coupon increases. However, the opposite is also true and the coupon falls when the base rate falls. Note that most bonds with floating coupons have an interest floor at an interest rate of zero (0); i.e. when the short-term interest rate is negative, the coupon does not change.