Chapter 06 – Bond Markets 6th edition
d. Bond Ratings and Interest Rate Spreads
Most bonds are rated in terms of default risk by at least one of the major ratings agencies,
typically Moody’s and/or Standard and Poors. Many institutions can hold only limited
amounts of unrated or low rated debt, so a favorable rating lowers the interest yield
required and increases the amount of potential buyers. Junk bonds are bonds rated
below Baa by Moody’s or BBB by S&P. Higher ratings are termed investment grade
bonds. Explanations of the ratings may be found in the text. In general ratings agencies
evaluate the industry strength, the firm’s position in the industry, liquidity, profitability,
debt capacity and since Sarbanes-Oxley, corporate governance. Each specific rated issue
is also examined for protection provided to investors as well as the firm’s ability to pay.
According to Alamo Capital, in May 2014 the average yield on 10 year A rated bonds
was 3.31% while the average yield on the 10 year Treasury was 2.48% for a default yield
spread of 83 basis points. The average rate on high yield debt was 5.27% providing an
additional credit spread of 196 basis points. On a $50 million bond issue, having a junk
rating would add an additional $980,000 in pre-tax interest expense per year. As you can
see, the rating substantially affects bond financing costs. Ratings spreads tend to vary
inversely with the phase in the cycle of the economy. From 1980 to 2002 the cumulative
default rate (CDFs) on 10 year Aaa rated bonds was 0.03% and the CDF was 9.63% on
Baa rated bonds.
The CDF for any year t of an N year bond can be calculated as
t
j
jt SurvivalobPr1CDF
To find the CDF after two years for an N year bond that has a 98% chance of survival in
year 1 and a 97% chance of survival thereafter:
%94.4)97.0*98.0(1SurvivalobPr1CDF
2
j
jt
Survive
97%
Survive
Year 1 98% Year 2 CDF
Decision
3% Tree
2% Don’t Survive
Don’t
Survive
Ratings agencies have been criticized for failing to downgrade firms quickly when
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Chapter 06 – Bond Markets 6th edition
conditions deteriorate.1 The Dodd-Frank bill allows investors to sue for ‘knowing or
reckless’ failure to properly rate certain risky securities. In hindsight, the ratings agencies
granted too high ratings to issuers of mortgage backed securities. The text discusses a
possible motivation for the ratings firms. The high ratings granted to certain tranches of
collateralized debt obligations (CDOs) allowed excessive issuance and excessive
leverage to be employed by hedge funds, banks and investment banks. This leverage
eventually led to the credit crunch and the demise of Bear Stearns.
As noted above, junk bonds (also called speculative grade or high yield bonds are those
rated below Baa3 or BBB-) carry considerably more risk and higher yields. The higher
yields may be necessary because many institutions are limited in the extent to which they
can hold junk debt. Junk bonds have often been used to finance takeovers, limiting the
amount of equity required by the acquirer. Junk issuance fell dramatically during the
crisis but rebounded on the low rates. Issuance was $2214 billion in 2011,$362.2 billion
in 2012 and $173.9 billion in the first half of 2013.
Bond Credit Ratings (Source: Text Table 6-10)
Explanation Moody’s S&P Fitch
Best quality; smallest degree of risk Aaa AAA AAA
High quality; slightly more long-term risk than
top rating
Aa1 AA+ AA+
Aa2 AA AA
Aa3 AA- AA-
Upper medium grade; possible impairment in the
future
A1 A+ A+
A2 A A
A3 A- A-
Medium grade; lacks outstanding investment
characteristics
Baa1 BBB+ BBB+
Baa2 BBB BBB
Baa3 BBB- BBB-
Speculative issues; protection may be very
moderate
Ba1 BB+ BB+
Ba2 BB BB
Ba3 BB- BB-
Very speculative; may have small assurance of
interest and principal payments
B1 B+ B+
B2 B B
B3 B- B-
Issues in poor standing; may be in default Caa CCC CCC
Speculative in a high degree; with marked
shortcomings Ca CC CC
Lowest quality; poor prospects of attaining real
investment standing CCC
Payment Default D D
1For more information see Frank Portnoy’s testimony before a U.S. Senate Committee on
January 24, 2002 on the Enron affair, available in Financial Engineering News June/July
2002, No. 26. Professor Portnoy is a law professor at the University Of San Diego
School Of Law.
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Source: alfred.stlouisfed.org
Chapter 06 – Bond Markets 6th edition
AAA and BAA yield spreads are shown in the graph below. Notice the increase in yield
spreads that occurred during the financial crisis.
Spreads contain more information than just default risk differences. For instance,
interest rate volatility is greater for lower rated bonds and riskier bonds often have
lower liquidity. Spreads will capture these differences whereas ratings only capture
the default risk differences.
Standard and Poors was sued by the U.S. government in 2013 for allegedly providing
optimistically biased ratings of mortgage backed securities. One wonders why S&P
was the only ratings agency sued. Pundits claim it is because only S&P lowered the
U.S. government’s debt rating.
a. Bond Market Indexes
Bond market indexes are published daily in the Wall Street Journal; indexes are available
for the major bond sectors. Table 6-11 in the text highlights the major indexes.
2. Bond Market Participants
Governments and foreign investors hold the bulk of Treasuries (see table below).
Municipal and corporate bonds are predominantly held by business financial institutions
although individuals hold % of municipals.
Bond market participants by type 2013 (See Text Figure 6–11)
Business
Financial
Business
Nonfinancial Governments
Household
s Foreign
Treasuries 21.83% 0.89% 19.07% 10.32% 47.89%
Municipals 52.58% 0.97% 0.28% 44.46% 1.71%
Corporate 59.33% <1% 1.01% 19.19% 20.47%
Percentage holdings of Treasuries by business financial entities doubled between 2007
and 2010 as safe investments were desired and the government increased the issuance of
Treasury debt.
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Chapter 06 – Bond Markets 6th edition
3. Comparison of Bond Market Securities
Yield rates on the three major bond types are presented in Text Figure 6-12. Yield rates
are highly correlated among the three types, but default risk premiums on muni and
corporate bonds can vary over time. As noted default spreads increased dramatically
during the financial crisis.
4. International Aspects of Bond Markets
International bond markets include issues underwritten by multinational syndicates or
bonds issued outside the home country. New issuance in this market grew dramatically
before the financial crisis. From 1995 to 2007 the annual quantity of international debt
securities issued grew from about $254 billion to $3,002 billion before the crisis reduced
new issuance which fell to $705 billion in 2012. Nevertheless the amount of international
bonds and notes outstanding grew from $2,209.3 billion in 1995 to $20,672.3 in March
2013, an overall growth rate of 835.7% over the period.
In terms of currency, there are now more euro denominated floating rate and fixed rate
debt instruments outstanding than dollar denominated instruments.2 International bonds
are usually bearer bonds placed in multiple countries or in a country other than the
issuer’s home country. Financial institutions are the largest issuers of international bonds,
other than equity related bonds which are dominated by corporate issuers.
In 2013 China was holding an estimated $1.32 trillion in U.S. Treasuries. Ask your
students what the effect would be if China sold their Treasury holdings. Is China likely to
do so? Why has China acquired so many Treasuries? The Chinese central bank has
acquired the Treasuries as a result of their attempts to keep the yuan low relative to the
dollar, albeit at the cost of domestic inflation in China.
Adding international bonds to a portfolio can improve diversification as foreign bond
correlations are lower than for domestic securities. However, some countries’ markets
are subject to sudden shifts in capital flows and thus risk is higher for these investments.
In addition currency movements may have major impacts on investment returns.
a. Eurobonds, Foreign Bonds, and Sovereign Bonds
b. Eurobonds
Eurobonds are long-term bonds sold outside the country of the currency in which they
are denominated. This need not be in Europe. For instance Eurodollar bonds may be
dollar denominated bonds sold in Japan. They typically have denominations of $5,000
and $10,000 and are traded mostly OTC in London and Luxembourg. Eurobonds are
typically placed by an investment banking syndicate, traditionally the issue costs have
been higher than for domestic bonds.
2 In equity related bonds and notes the U.S. dollar still dominates.
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Eurobond growth was hindered by the Euro/Greek crisis. New issuance fell from $1.5
trillion in 2007 to $947 billion in 2008 and falling all the way to $76 billion in 2012. The
International Swap Dealer’s Association (ISDA) ruled a restructuring of Greek debt a
‘credit event’ because investors were forced to accept a haircut. This resulted in required
payments on credit default swaps and panicked the markets. The ECB eventually
provided a $480 billion bailout. European growth in 2014 is increasing slightly but
deflationary pressures and subpar growth rates remain.
c. Foreign Bonds
Foreign bonds are bonds issued outside the home country and are denominated in the
host country’s currency. For example, Samurai bonds are dollar denominated bonds
issued by Japanese borrowers in the U.S.
d. Sovereign Bonds
Sovereign bonds are government issued debt. Most LDC sovereign debts are issued in a
strong currency such as the dollar or euro rather than in the issuing countries home
currency. Emerging market debt is often not rated investment grade and carries higher
interest rates. In this era of low rates, yields on these bonds can appear attractive,
offering spreads of between 400 and 1500 or more basis points over U.S. Treasuries.
Spreads increased dramatically during the financial crisis, in some cases tripling in a few
weeks. In 2009, Dubai World could not make its interest payment on its debt. In Europe,
Greece, Ireland and Portugal all required bailouts to avoid debt defaults. A private lender
cannot force a government to pay its debts. Argentina has defaulted three times. The
International Monetary Fund and other lending facilities usually assist in bailing out
sovereign debts, usually with certain conditions that the country must meet.
1.1.1.1 VI. Web Links
http://www.publicdebt.treas.gov Bureau of the Public Debt; this site has the current
amount of public debt.
http://www.nyse.com/ An excellent website of the New York Stock
Exchange.
http://www.ft.com/ Financial Times, won two Espy awards for best new
site and best non U.S. news site. Coverage of
global events and markets.
http://www.moodys.com/ A leading provider of independent credit ratings,
research and financial information to the capital
markets
http://www.standardandpoors.com/ A leading provider of independent credit ratings,
research and financial information to the capital
markets
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Chapter 06 – Bond Markets 6th edition
http://www.fitchratings.com/ A leading provider of independent credit ratings,
research and financial information to the capital
markets
1.1.1.1.1.1 http://www.ny.frb.org/ Federal Reserve Bank of New York website, complete
with research, links to the Treasury Direct program
and job opportunities.
1.1.1.1.1.2 VII. Student Learning Activities
1. Go to the web page of the Bond Market Association:
http://www.investinginbonds.com and use their recommendations to ascertain what
percentage of your personal investment portfolio should currently be in bonds.
2. Go to http://www.marketwatch.com/tools/bonds/ and examine the average yield
spreads between the investment grade, high yield and convertible bonds. Explain the
differences you find.
3. Go to the SEC’s website and investigate ‘yield burning’ on municipal bonds. What is
yield burning? Who is concerned about this practice? Why?
4. Read the article, “Financial Contracting Under Extreme Uncertainty: An Analysis of
Brazilian Corporate Debentures,” Anderson, Journal of Financial Economics: 1999.
What additional factors must a bondholder consider in international investing? How
can the additional factors be handled?
5. Why did bond market activity boom immediately after the financial crisis of
2007-2008? How were large firms and small firms affected differently by the crisis?
Explain.
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