Chapter 18
Corporate and Government Bonds
Slides
18-1. Chapter 18
18-2. Corporate and Government Bonds
18-3. Learning Objectives
18-4. Corporate and Government Bonds
18-5. Corporate Bond Basics, I.
18-6. Corporate Bond Basics, II.
18-7. Corporate Bond Basics, III.
18-8. Bond Market Trading
18-9. Types of Corporate Bonds
18-10. Bond Indentures
18-11. Bond Indentures, Seniority Provisions
18-12. Bond Indentures, Fixed-Price Call Provisions
18-13. Maximum Price of a Fixed-Price Callable Bond
18-14. Bond Indentures, Make-Whole Call Provisions
18-15. Bond Indentures, Put Provisions
18-16. Bond Indentures, Bond-to-Stock Conversion Provisions
18-17. Convertible Bond Prices and Conversion Values
18-18. Bond Indentures, Bond Maturity Provisions
18-19. Bond Indentures, Principal Payment Provisions
18-20. Protective Covenants
18-21. Adjustable Rate Bonds, I
18-22. Adjustable Rate Bonds, II
18-23. Government Bond Basics
18-24. U.S. Treasury Bills (T-bills)
18-25. U.S. Treasury Notes (T-notes)
18-26. U.S. Treasury Bonds (T-bonds)
18-27. U.S. Treasury STRIPS
18-28. Example: Calculating the Price of a STRIPS
18-29. Zero Coupon Bond Prices by Yield to Maturity and Maturity
18-30. Zero Coupon Bond Prices
18-31. WSJ Prices for Treasury Bonds and Notes
18-32. Straight Bond Prices and Yield to Maturity
18-33. Treasury Bond Prices and YTM for Different Maturities
18-34. Inflation-Indexed Treasury Securities, I.
18-35. Inflation-Indexed Treasury Securities, II.
18-36. Inflation-Indexed Treasury Securities, III.
18-37. U.S. Treasury, General Auction Pattern
18-38. U.S. Treasury Auctions, Details
18-39. U.S. Treasury Auctions, II.
18-40. Federal Government Agency Securities, I.
18-41. Federal Government Agency Securities, II.
18-42. Federal Government Agency Securities, III.
18-43. Municipal Bonds, I.
18-44. Municipal Bonds, II.
18-45. Municipal Bonds, III.
18-46. Municipal Bond Features
18-47. Municipal Bond Price Quotes
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill
Education.
Corporate and Government Bonds 18-2
18-48. Types of Municipal Bonds
18-49. Municipal Bond Insurance
18-50. Equivalent Taxable Yield
18-51. Example: Equivalent Taxable Yield
18-52. Example: Critical Marginal Tax Rate
18-53. Taxable Municipal Bonds
18-54. Corporate Bond Credit Ratings
18-55. Corporate Bond Credit Rating Symbols
18-56. The Importance of Corporate Bond Credit Ratings
18-57. An Alternative to Bond Ratings
18-58. The Yield Spread
18-59. Corporate Yield Spreads Through Time
18-60. High Yield Bonds (“Junk” Bonds)
18-61. High Yield Bond Quotes
18-62. Useful Websites
18-63. Chapter Review, I.
18-64. Chapter Review, II.
Chapter Organization
18.1 Corporate Bond Basics
18.2 Corporate Bond Indentures
A. Bond Seniority Provisions
B. Call Provisions
C. Put Provisions
D. Bond-to-Stock Conversion Provisions
E. Graphical Analysis of Convertible Bond Prices
F. Bond Maturity and Principal Payment Provisions
G. Sinking Fund Provisions
H. Coupon Payment Provisions
I. Protective Covenants
J. Adjustable-Rate Bonds
18.3 Government Bond Basics
18.4 U.S. Treasury Bills, Notes, Bonds, and STRIPS
A. Treasury Bond and Note Prices
B. Treasury Inflation-Protected Securities
18.5 U.S. Treasury Auctions
18.6 Federal Government Agency Securities
18.7 Municipal Bonds
A. Municipal Bond Features
B. Types of Municipal Bonds
C. Municipal Bond Insurance
D. Equivalent Taxable Yield
E. Taxable Municipal Bonds
18.8 Bond Credit Ratings
A. Why Bond Ratings are Important
B. An Alternative to Bond Ratings
C. Junk Bonds
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill
Education.
Corporate and Government Bonds 18-3
18.9 Summary and Conclusions
Selected Web Sites
www.investinginbonds.com (for more information on bonds)
www.sec.gov (U.S. Securities and Exchange Commission)
www.treasurydirect.gov (lots of information on Treasury securities)
www.ustreas.gov (visit the U.S. Treasury)
www.municipalbonds.com (check out munis)
www.mbia.com (bond insurance company)
www.ambac.com (bond insurance company)
finance.yahoo.com (information on credit spreads)
www.stlouisfed.org (St. Louis Federal Reserve Bank—credit
spreads)
Websites for Rating Agencies:
www.duffandphelps.com (Duff and Phelps, LLC.)
www.fitchratings.com (Fitch Investors Service)
www.moodys.com (Moody’s)
www.standardandpoors.com (Standard & Poor’s)
Annotated Chapter Outline
18.1 Corporate Bond Basics
Plain Vanilla (or Bullet) Bonds: Bonds issued with a relatively standard
set of features.
Unsecured Debt (or debenture): Bonds, notes, or other debt issued with
no specific collateral pledged as security for the bond issue.
Corporate bonds represent the debt of a corporation owed to its bondholders.
The fixed sum paid at maturity is the principal, par value, or face value, and the
periodic interest payments are coupons. The three main differences between
corporate bonds and stock are:
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill
Education.
Corporate and Government Bonds 18-4
Common stock is an ownership claim on the corporation, whereas bonds
represent a creditor’s claim on the corporation.
Coupons and principal, the promised cash flows, are stated in advance,
whereas the amount and timing of stock dividends may change at any
time.
Most corporate bonds are callable, whereas common stock is almost
never callable.
There are several trillion dollars in the corporate bond market, with the largest
investors being life insurance companies. Every bond issue has specific terms
associated with it, from relatively simple to fairly complex. Bonds issued with
standard, relatively simple features are called plain vanilla bonds.
18.2 Corporate Bond Indentures
Indenture Summary: This is a description of the contractual terms of a
new bond issue included in a bond’s prospectus.
Prospectus: Document prepared as part of a security offering detailed
information about a company’s financial position, its operations, and
investment plans.
A bond indenture is a formal written agreement between the corporation and the
bondholders that spells out the rights and obligations of both parties. It is quite
lengthy, so many investors refer to the indenture summary in the prospectus. The
Trust Indenture Act of 1939 requires that any bond issue subject to SEC
regulation must have a trustee appointed to represent the bondholders.
Private Placement: A new bond issue sold to one or more parties in
private transactions not available to the public.
If a bond is not sold to the general public, an indenture is not required (Trust
Indenture Act of 1939). Private placements are sold to one or more parties in a
private transaction and are exempt from SEC registration requirements. When
there is no indenture, the debt is basically a simple IOU of the corporation. Many
bond analysts refer to corporate debt with an indenture as a bond and without as
a note.
A. Bond Seniority Provisions
Senior Debentures: Bonds that have a higher claim on the firm’s assets
than other bonds.
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill
Education.
Corporate and Government Bonds 18-5
Subordinated Debentures: Bonds that have a claim on the firm’s assets
after those with a higher claim have been satisfied.
Negative Pledge Clause: Bond indenture provision that prohibits new
debt from being issued with seniority over an existing issue.
A corporation may have several different bond issues outstanding, and these
issues normally are differentiated according to the seniority of their claims on the
firm’s assets. Seniority usually is specified in the indenture contract. The seniority
is usually protected by a negative pledge clause, which prohibits a new issue of
debt with seniority above a currently outstanding issue.
B. Call Provisions
Bond Refunding: Process of calling an outstanding bond issue and
refinancing it with a new bond issue.
Most corporate bond issues have a call provision to buy back outstanding bonds
at a specified price before the bonds mature. The firm may want to call high-
interest bonds and replace them with lower-interest bonds when interest rates
decrease. Callable bonds are not as attractive to an investor, so they should sell
at a lower price. There are two major types of call provisions: traditional fixed-
price and make-whole.
Traditional Fixed-Price Call Provisions: From an investor’s point of view, a fixed-
price call provision has a distinct disadvantage. For example, suppose an
investor is currently holding bonds paying 10 percent coupons. Further suppose
that, after a fall in market interest rates, the corporation is able to issue new
bonds that only pay 8 percent coupons. By calling existing 10 percent coupon
bonds, the issuer forces bondholders to surrender their bonds in exchange for
the fixed call price. But this happens at a time when the bondholders can reinvest
funds only at lower interest rates. If instead the bonds were non-callable, the
bondholders would continue to receive the original 10 percent coupons. For this
reason, callable bonds are less attractive to investors than non-callable bonds.
Consequently, a callable bond will sell at a lower price than a comparable non-
callable bond.
A non-callable bond has the standard convex price-yield relationship, that is, the
price-yield curve is bowed toward the origin. When the price-yield curve is bowed
to the origin this is called positive convexity. In contrast, the fixed-price callable
bond has a convex or bowed price-yield relationship in the region of high yields,
but it is bowed away from the origin in the region of low yields. This is called
negative convexity.
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill
Education.
Corporate and Government Bonds 18-6
The important lesson here is that no matter how low market interest rates might
fall, the maximum price of an unprotected fixed-price callable bond is generally
bounded above by its call price.
Make-Whole Call Provision: In recent years, a new type of call provision, a
“make-whole” call, has become common in the corporate bond market. If a
callable bond has a make-whole call provision, bondholders receive
approximately what the bond is worth if the bond is called. This call provision
gets it name because the bondholder does not suffer a loss in the event of a call;
that is, the bondholder is “made whole” when the bond is called.
Like a fixed-price call provision, a make-whole call provision allows the borrower
to pay off the remaining debt early. Unlike a fixed-price call provision, however, a
make-whole call provision requires the borrower to make a lump-sum payment
representing the present value of all payments that will not be made because of
the call.
The discount rate used to calculate the present value is usually equal to the yield
of a comparable maturity U.S. Treasury security plus a fixed, pre-specified make-
whole premium. Because the yield of a comparable U.S. Treasury security
changes over time, the call price paid to bondholders changes over time. As
interest rates decrease, the make-whole call price increases because the
discount rate used to calculate the present value decreases.
As interest rates increase, the make-whole call price decreases. In addition,
make-whole call provisions typically specify that the minimum amount received
by a bondholder is the par value of the bond. As interest rates decline, even in
the region of low yields, the price of bonds with a make-whole call provision will
increase. That is, these bonds exhibit the standard convex price-yield
relationship in all yield regions. In contrast, recall that bond prices with a fixed
price call provision exhibit negative convexity in the region of low yields.
Effective Duration: For standard bonds, Macaulay and modified duration
are relevant. However, these fail to account for embedded options in
bonds. Thus, for callable bonds the effective duration is more relevant.
C. Put Provisions
Put Bonds: A bond that can be sold back to the issuer at a prespecified
price on any of a sequence of prespecified dates. These bonds are also
called extendible bonds.
Put bonds are “putable” on a series of designated put dates. The put feature
creates a floor on the market price of the bond, and it also protects bondholders
from corporate acts that may hurt credit quality.
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill
Education.
Corporate and Government Bonds 18-7
D. Bond-to-Stock Conversion Provisions
Convertible Bonds: Bonds that can be exchanged for common stock
according to a prespecified conversion ratio.
Convertible bonds grant bondholders the right to exchange each bond for a
designated number of common stock shares of the issuing firm. The important
terms are:
Conversion ratio:
CR = No. of stock shares acquired by conversion
Conversion price:
CP = Bond par value / Conversion ratio
Conversion value:
CV = Price per share of stock x Conversion ratio
When is the optimum time to convert? The rational decision is to postpone
converting as long as possible because the investor will want to receive as many
coupon payments as possible. If the bonds are callable, the firm may force
conversion by calling the bonds when the conversion value has risen 10-15%.
E. Graphical Analysis of Convertible Bond Prices
In-the-Money Bond: A convertible bond whose conversion value is
greater than its call price.
Intrinsic Bond Value: The price below which a convertible bond cannot
fall, equal to the value of a comparable nonconvertible bond. This is also
called investment value.
Exchangeable Bonds: Bonds that can be converted into common stock
shares of a company other than the issuer’s.
The price of a convertible bond is closely linked to the value of the underlying
shares. This relationship is shown in Figure 18.3.
F. Bond Maturity and Principal Payment Provisions
Term Bonds: Bonds issued with a single maturity date.
Serial Bonds: Bonds issued with a regular sequence of maturity dates.
Term bonds, which have a single maturity date, are the most common corporate
bond maturity structure. The indenture normally stipulates a sinking fund to repay
bondholders through fractional redemptions before maturity.
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill
Education.
Corporate and Government Bonds 18-8
G. Sinking Fund Provisions
A sinking fund provides more security to bondholders, but, since it requires
periodic fractional bond issue redemptions, some bondholder will have their
bonds called early. The firm’s trustee either buys back the bonds in the open
market or calls the bonds by lottery, depending on the level of interest rates
(bond prices).
H. Coupon Payment Provisions
Coupon rates are stated on an annual basis, although almost all corporate bonds
pay interest semiannually. The bond indenture states exact payment dates. If a
firm suspends payment of coupon interest, it is in default. In the case of default,
bondholders could demand an acceleration of principal repayment and all past
due interest, but it is usually best to negotiate a new debt contract.
I. Protective Covenants
Protective Covenants: Restrictions in a bond indenture designed to
protect bondholders.
There are two types of protective covenants, negative and positive. Some
examples include:
Thou shalt not (negative covenants):
– Pay dividends beyond specified amount.
– Sell more senior debt.
– Refund an existing bond issue with new bonds paying a lower interest
rate.
– Buy another company’s bonds.
Thou shalt: (positive covenants):
– Use proceeds from sale of assets for other assets.
– Limit the amount of new debt
– Allow redemption in event of merger or spin-off.
– Maintain assets in good condition.
– Provide audited financial information.
J. Adjustable-Rate Bonds
Adjustable-Rate Bonds: These securities pay coupons that change
according to a pre-specified rule, also called floating-rate bonds, or simply
floaters.
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill
Education.
Corporate and Government Bonds 18-9
Many bond, note, and preferred stock issues allow the issuer to adjust the annual
coupon based on current interest rates. Adjustable-rate bonds are also called
floating rate or floaters. Adjustable-rate bonds are often putable at par value.
Inverse floaters have coupons that change inversely with interest rates, thereby
creating increased pricing volatility.
18.3 Government Bond Basics
The U.S. federal government is the largest borrower in the world, with more than
$18 trillion in public debt as of November 2015. The U.S Treasury manages the
debt as the financial agent of the federal government. The debt is financed
through marketable and nonmarketable securities. Marketable securities, the
larger group of the two, include Treasury bills, Treasury notes, and Treasury
bonds. Nonmarketable securities include U.S. Savings Bonds, Government
Account Series, and State and Local Government Series. Treasury security
ownership is registered with the U.S Treasury, and marketable security
ownership can be transferred when the securities are sold. Nonmarketable
securities do not allow transfer of registered ownership. Another large market for
government debt is municipal government debt, currently at over $3.5 trillion.
18.4 U.S. Treasury Bills, Notes, Bonds, and STRIPS
Face Value: Also called redemption value. The value of a bill, note or
bond at maturity is the face value because the face value is paid at
maturity.
Discount Basis: This is a method of selling a Treasury bill at a discount
from face value.
Imputed Interest: The interest paid on a Treasury bill determined by the
size of its discount from face value.
STRIPS: Treasury program allowing investors to buy individual coupon
and principal payments from a whole Treasury note or bond. Acronym for
Separate Trading of Registered Interest and Principal of Securities.
Zero Coupon Bond: A note or bond paying a single cash flow at maturity.
Also called zeroes.
The basic characteristics of T-bills, T-notes, T-bonds, and STRIPS are:
T-bills
– Short-term, one year or less: 4, 13, or 26 weeks
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill
Education.
Corporate and Government Bonds 18-10
– Face value (redemption value)
– Sold on a discount basis
– Imputed interest
T-notes
– Medium-term, 10 years or less; 2, 5, or 10 years
– Semiannual coupons
T-bonds
– Long-term, 30 years
– Semiannual coupons
STRIPS
– From T-notes and T-bonds
– Separate Trading of Registered Interest and Principal of Securities
(STRIPS)
– Coupon strips and principal strips
– Effectively become zero coupon bonds
A. Treasury Bond and Note Prices
Bid-Ask Spread: The difference between a dealer’s bid and ask prices.
Treasury bond and note prices are quoted on a percentage of par basis, and
fractions of a percent are stated in thirty-seconds. Since 1985, the Treasury has
only issued noncallable bonds. Because T-bonds and notes pay interest
semiannually, the price and yield are calculated using the bond price formula
discussed in earlier chapters.
B. Treasury Inflation-Protected Securities
In recent years, the U.S Treasury has issued inflation-indexed securities, which
pay a fixed coupon rate on their current principal and adjust their principal
semiannually according to the most recent inflation rate.
For example, suppose an inflation-indexed note is issued with a coupon rate of
1.5 percent and an initial principal of $1,000. Assuming 2 percent inflation over
the six months since issuance, the note’s principal is then increased to $1,000 ×
102% = $1,020. The note will pay a coupon of $1,020 × 1.5% / 2 = $7.65.
Lecture Tip: You will have to point out (very carefully) to students that while the
coupon rate remains the same, the coupon payment will change.
Price and yield information for inflation-indexed Treasury securities is reported in
The Wall Street Journal in the same section as other Treasury securities.
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill
Education.
Corporate and Government Bonds 18-11
18.5 U.S. Treasury Auctions
Stop-out Bid: The lowest competitive bid in a U.S Treasury auction that is
accepted.
The Federal Reserve Bank regularly conducts auctions for T-bills, T-notes, and T–
bonds. 13- and 26-week T-bills are auctioned weekly, 52-week T-bills are
auctioned every four weeks, two-year notes are auctioned monthly, longer
maturity notes are auctioned each quarter, and T-bonds are sold three times per
quarter. The Fed accepts sealed bids of two types: competitive and
noncompetitive. The competitive bids specify a bid price and quantity.
Noncompetitive bids specify a quantity, since the price will be determined by the
results of the competitive bid process. The stop-out bid is determined, the price
at which all competitive bids are sufficient to finance the issue amount, and
competitive bids above the stop-out bid are accepted. All noncompetitive bids
and accepted competitive bids pay the stop-out bid. Individual investors can
submit noncompetitive bids, but only Treasury security dealers can submit
competitive bids. The bid process is similar for T-bond and T-note issues, except
that bids are made on a yield basis.
18.6 Federal Government Agency Securities
Most U.S government agencies consolidate their borrowing through the Federal
Financing Bank, which obtains funds from the U.S. Treasury. Several agencies
issue directly to the public, including: the Resolution Trust Funding Corporation,
the World Bank, and the Tennessee Valley Authority. These bonds share an
almost equal credit quality with U.S Treasury issues, although there is not an
explicit U.S. government guarantee. These notes and bonds are attractive
because they pay higher yields than comparable U.S. Treasury securities. The
market for these securities is less active, so bid-ask spreads are higher. Also,
agency bonds are subject to state and local taxation in addition to federal
taxation but Treasury securities are only subject to federal taxation.
18.7 Municipal Bonds
Default Risk: The risk that a bond issuer will cease making scheduled
payments of coupons or principal, or both.
General Obligation Bonds (GOs): Bonds issued by a municipality that
are secured by the full faith and credit of the issuer.
Municipal notes and bonds are issued by state and local governments or
agencies, and they are often called “munis.” Coupon interest is usually exempt
from federal income tax, and most states exempt interest from state income tax if
the bond is issued in that state. These tax advantages make muni bonds
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill
Education.
Corporate and Government Bonds 18-12
attractive to investors in higher income tax brackets. Yields on “munis” are less
than comparable corporate debt. Municipal debt often has a high credit rating,
but default risk does exist.
A. Municipal Bond Features
Municipal bonds are typically callable, pay semiannual coupons, and have a par
value of $5,000. Prices are stated as a percent of par value, but dealers
commonly use yield quotes. Most municipal bonds are callable, but they usually
have a period of call protection, and the call price usually includes a call
premium. Most munis are issued as serial bonds, but some are term bonds with
a sinking fund provision. Also, some munis are putable and others are variable-
rate. Inverse floaters are like variable-rate bonds, but they pay a variable coupon
rate that moves inversely with market interest rates.
B. Types of Municipal Bonds
Revenue Bonds: Municipal bonds secured by revenues collected from a
specific project or projects.
Hybrid Bonds: Municipal bonds secured by project revenue with some
form of general obligation credit guarantee.
There are two basic types of municipal bonds: revenue bonds and general
obligation bonds (GOs). They are issued by all levels of municipal governments
and secured by the general taxing powers of the municipalities. They are also
called “unlimited tax bonds,” or “full faith and credit bonds.” “Limited tax bonds”
occur when a constitutional limit is placed on the power of the municipality to
assess taxes. Revenue bonds are secured by the proceeds collected from the
projects they finance, and they constitute the bulk of all municipal bonds. A hybrid
bond is a revenue bond secured by project-specific cash flows, but with
additional credit guarantees. Since 1983, all newly issued municipal bonds have
had to be registered.
C. Municipal Bond Insurance
Insured Municipal Bonds: Bonds secured by an insurance policy that
guarantees bond interest and principal payments should the issuer
default.
Many municipalities obtain bond insurance for new bond issues. These insurance
policies are written by a commercial insurance company. The cost of the policy is
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill
Education.
Corporate and Government Bonds 18-13
paid by the issuer. The insurance usually results in a higher credit rating, which
allows the bond to sell at a higher price.
Municipal bond insurance companies manage risk by:
Insuring bond issues from municipalities with good credit ratings.
Writing policies across a wide geographic area.
Maintaining substantial investment portfolios as a source of financial
reserves.
D. Equivalent Taxable Yield
To compare corporate and municipal bonds, an investor must compare the yields
on an equivalent tax basis, as follows:
Equivalent taxable yield = Tax-exempt yield / (1 – Marginal tax rate)
or
After-tax yield = Taxable yield x (1 – Marginal tax rate)
To calculate the investor indifference point:
Critical marginal tax rate = 1 – [(Tax-exempt yield) / Taxable yield]
Lecture Tip: Municipal bonds tend to be an investment category that is not as
appealing to students. When discussing munis it is important to emphasize the
size of the muni market and the tax benefits of investing in munis.
E. Taxable Municipal Bonds
Private Activity Bonds: Taxable municipal bonds used to finance facilities
used by private businesses.
The 1986 Tax Reform Act imposed restrictions on the types of municipal bonds
that qualify for federal tax exemption of interest payments. Private activity bonds
include any municipal security (1) where 10% or more of the issue finances
facilities used by private entities and (2) that is secured by payments from private
entities. Interest is tax-exempt only if the bond issue falls into a qualified
category.
18.8 Bond Credit Ratings
Credit Rating: An assessment of the credit quality of a bond issue based
on the issuer’s financial condition.
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill
Education.
Corporate and Government Bonds 18-14
When a corporation sells a new bond issue, it usually subscribes to several bond
rating agencies for a credit evaluation and credit rating. There are several
established rating agencies, such as: Duff and Phelps; Fitch Investors Service;
McCarthy; Crisanti and Maffei; Moody’s Investors Service; and Standard and
Poor’s. These ratings apply to a specific bond issue and not to the issuer of the
bonds. Further, these ratings are not guaranteed and are subject to change.
There are three broad categories of bond credit ratings: investment grade,
speculative grade, and extremely speculative grade.
A. Why Bond Ratings Are Important
Prudent Investment Guidelines: Restrictions on investment portfolios
stipulating that securities purchased must meet a certain level of safety.
These credit ratings are important because only a few institutional investors have
the resources and expertise to properly evaluate a bond’s credit quality on their
own. Many corporations and individual investors rely on these credit ratings. In
fact, many financial institutions and pension funds have investment safety
requirements, such that the bonds in their portfolios are limited to investment
grade bonds with a minimum credit rating.
B. An Alternative to Bond Ratings
Credit spreads measure the required yield above a comparable term Treasury
security. Higher spreads are correlated with lower credit ratings; however, the
spreads are much more responsive to changes.
C. Junk Bonds
High-Yield Bonds: Bonds with a speculative credit rating that is offset by
a yield premium offered to compensate for higher credit risk. These bonds
are also called junk bonds.
Bonds with a speculative or low credit rating, those rated Ba (Moody’s) or BB
(S&P) or lower, are called high-yield or junk bonds. High-yield bonds can be
fallen angels or original-issue junk. Junk bonds offer a yield premium in
exchange for the risk associated with their higher default rate. Even though high-
yield bonds are riskier, they may still be appropriate for a diversified portfolio.
18.9 Summary and Conclusions
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill
Education.