The Basics of Corporate Debt and Credit Risk
Before getting into the details of corporate bonds, we should quickly review the basics of debt and credit risk. It is important context for understanding the role of debt in corporate capital structure.
Most corporations are financed with a combination of equity and debt. Debt is a form of borrowing that has set repayment terms and does not transfer control unless those terms are breached. In other words, debt is not an ownership share in the firm. This makes debt different from equity, which is a form of ownership that involves a claim on earnings and various degrees of control. In a debt contract, the borrower is an “obligor,” meaning that the borrower is obligated to make certain payments to the lender.
The degree to which a corporation is financed with debt is leverage. The “leverage ratio” measures the degree to which a firm is financed with debt. All corporations have equity, because the corporation must have an owner. However, the corporation may or may not have debt. Some startups and tech firms have no debt. In other industries, like oil and gas, many corporations have large amounts of debt. A firm that issues a significant amount of debt relative to equity has a high degree of leverage.
In a debt contract, the firm raises money by agreeing to pay interest on the money and return it at a specified point in time in the future. The advantage of debt from the borrower perspective is that the owner does not need to give away any of the upside potential of earnings or transfer control. The disadvantage of debt from the borrower perspective is that it is a fixed obligation regardless of firm performance. If the firm’s performance declines, the firm is still obligated to make the debt payments. This can be very difficult when there is a significant amount of debt.
Credit risk is the more common term for default risk. Default risk is the risk that the obligor will not make the contractual payments in the debt contract. Delinquency is when a payment is missed for a period of time. The borrower can be 30-days, 60-days, or 90-days past due. Default typically refers to a debt contract that has gone 90-days past due and will not be making future payments. An obligor that has failed to make the contract payments is “in default.” You can think of this as a legal term for breach of contract.
Corporate Bonds and the Bond Market
Corporate bonds are issued by corporations to raise capital in the form of debt. They are longer-maturity corporate debt, with a maturity of more than 1 year. This is in contrast to short-term forms of corporate debt with a maturity of 1 year or less, such as commercial paper. Corporate bonds are also distinct from bank loans. They are debt instruments issued to a dispersed group of investors rather than a single financial institution. Therefore, corporate bonds are part of capital markets, similar to stocks.
The primary market for corporate bonds involves the initial issuance of the bonds. Typically a corporation will hire an investment bank to arrange the bond issuance. This can be thought of as a less-intensive version of an initial public offering (IPO) of equity. The investment bank helps the firm raise debt capital by helping sell the bonds to investors. The sell side of the corporate bond market is issuance of the securities by the investment bank and the buy side of the market is the purchasing of the securities by investors.
The corporate bond market involves the primary market for bond issuance as well as the secondary market for trading corporate bonds. Corporate bonds can be bought and sold by investors just like stocks. However, the bond market is not as centralized as the stock market. The stocks of public companies trade on stock exchanges like the New York Stock Exchange, which is a centralized form of trading. Corporate bonds trade in an over-the-counter (OTC) market, which is a decentralized form of trading. OTC markets are created by financial institutions called broker-dealers that buy and sell securities that trade “off exchange.” A broker-dealer functions as a broker by connecting buyers and sellers and as a dealer by transacting directly with buyers and sellers. In other words, a broker facilitates the trade between the buyer and seller whereas a dealer is part of the trade as a buyer or seller. Corporate bonds are not amenable to exchanges because they are terminal contracts with multiple contractual terms. A company has one price for its common shares but can have 100 prices for its various bonds on the market. Broker-dealers create a market for corporate bonds by providing liquidity to buyers and sellers.
The Credit Risk of Corporate Bonds
Corporate bonds have credit risk. In other words, corporations sometimes default on their debt obligations and fail to make the scheduled payments in the bond contract. In the U.S., this is how corporate bonds differ from sovereign bonds. You can think of U.S. Treasuries as being risk-free, because they have negligible credit risk. Only in the event of a government shutdown and inability to raise taxes will the U.S. government fail to make interest payments. In contrast, corporations do not have the power to tax citizens. If a corporation enters financial distress, it may be forced to default on its corporate bonds. Some sovereign bonds can have credit risk if the country’s economy is under significant distress (e.g., Greece and Argentina). In these countries, the local corporations typically have credit risk that is over-and-above the local sovereign credit risk, because the corporations are tied to the local economy.
Corporations with greater credit risk must compensate their investors to bear this risk. This is the fundamental relationship between risk and return in finance. Riskier corporations must pay higher interest rates. This compensates investors for the possibility of missed payments in the future.
Another way of saying this is that corporate bonds must pay their investors a higher yield. In the bond market, the total return to the bond investor is measured using yield to maturity (YTM). Bonds with greater credit risk will have higher yield to maturity. You can think of yield to maturity as a required rate of return on a bond. When a bond is risky, it will have a high required rate of return, just like a stock.
There are many reasons why a corporate bond can have high credit risk and high yield. One factor is expected earnings, which is similar to stock valuation. Whereas equity valuation focuses on the upside potential of future earnings, bond valuation focuses on the downside risk of future earnings. Bond investors try to assess the probability of weak earnings, but this will help predict the probability of default. A firm with weak earnings has a higher probability of default, so investors will require a high yield to be compensated for this risk. A second factor is leverage. A firm with high leverage (a highly “leveraged” or “levered” firm) will have more difficulty making its debt payment if it becomes financially distressed. Therefore, bond investors also focus on the amount of debt outstanding relative to earnings. Corporations with high leverage tend to pay a high yield on their corporate bonds.
Credit Risk in Bond Valuation
Credit risk can show up in two places in bond valuation. As a reminder, the basic equation for a two-year bond that pays annual coupon payments is the following:
A corporation with high credit risk will issue bonds with a high coupon rate. This higher coupon rate is the compensation for investors who buy the bond at issuance. For instance, a corporation with low credit risk may issue bonds with a 5% coupon rate and a corporation with high credit risk may issue bonds with a 10% coupon rate. Both bonds can be issued at par value, in which price equals face value. If this is the case, the low risk bond will have a yield-to-maturity of 5% and the high risk bond will have a yield-to-maturity of 10%. The investors in the risky bond are compensated through the higher coupon rate.
The other way in which bond investors can be compensated for credit risk is in the bond price. Corporate credit risk changes over time. If a corporation’s credit risk increases after a bond has been issued, the yield on the bond will increase through a decline in price. The coupon rate will remain unchanged (it is fixed at issuance), but the yield to maturity will increase. You can think of this as a result of changing investor demand. If the credit risk of a bond increases, investor demand for that bond will decrease. When demand for a security decreases, the price of that security decreases. This reduced price is now a factor in the bond yield and will result in a higher yield to maturity.
Suppose that the bond issued at par with a coupon rate of 5% becomes riskier after issuance. The firm’s performance weakens and probability of default increases. Demand for the bond will fall because the bond is only paying 5% but now has greater risk. As demand declines, the price of the bond decline and the bond will be trading at a discount (price less than face value). Holders of the bond will suffer a capital loss. Investors who are considering the bond are now looking at a price that is less than face value. If they buy the bond and hold it to maturity, their yield to maturity will be greater than the coupon rate. In this case, the YTM will be greater than 5%. This is how yield on a bond can increase after issuance due to an increase in credit risk after issuance.
Just like in the stock market, the bond market has low-risk and high-risk investors. Some investors prefer bonds with low credit risk and are willing to accept low yields. Some investors prefer bonds with high credit risk and are seeking higher yields. The realization of credit risk will determine who makes more money. If actual defaults turn out to be low, the high-yield investor will make more money. However, if actual defaults turn out to be high, the low-yield investor may make more money because the high-yield investor does not get repaid.
The Role of Credit Ratings Agencies
In the world of personal finance, credit risk is measured using FICO scores. FICO scores can range from 300 to 850 and a score of 670 or above is considered a good credit score. A borrower with a low FICO score has a higher probability of defaulting on their debt. Consequently, these borrowers may have a hard time being approved for credit and will have to pay higher interest rates. There are three credit agencies for personal finance in the U.S.: Equifax, Experian, and TransUnion.
Credit risk for corporate bonds is measured in credit ratings. Like credit scores, a credit rating is a measure the ability of the borrower to repay. The highest credit rating for a corporate bond is AAA. As the credit rating declines from AAA, credit risk increases and yield increases. This forms a fundamental relationship. High rating means low yield and low rating means high yield.
There are three credit rating agencies for corporate bonds: Moody’s, S&P, and Fitch. They each have their own rating scale, which is shown here. These ratings agencies are private, for-profit companies, but they are given regulatory certification by the SEC as Nationally Recognized Statistical Ratings Organizations (NRSROs). The SEC provides a public list of the current NRSROs. Moody’s, S&P, and Fitch are sell-side ratings agencies, which means that they are paid to rate the bonds by the investment bank that is issuing the bonds. This creates an inherent conflict of interest, which was highlighted in regard to mortgage-backed securities in the movie The Big Short. Most bonds have two ratings, so investment banks can do “rating shopping” for the best ratings. There was discussion after the financial crisis about greater reform of the ratings agencies, but there was not sufficient agreement about how to change the system. Other ratings agencies like Egan-Jones are buy-side rating agencies, which means that they are paid by investors.
The corporate bond market is segmented into investment grade and non-investment grade. Investment grade bonds have a credit rating at or above the following ratings: Baa3 (Moody’s), BBB- (S&P), and BBB- (Fitch). These are the highest quality bonds on the market, meaning they have the lowest credit risk. Many institutional investors, such as pension funds, have investment mandates that have specific rules about whether or how much the fund can invest in non-investment grade bonds.
The high yield bond market includes bonds in the non-investment grade category. These bonds are called high yield because they have high credit risk and pay higher returns. This is also referred to as the “junk bond” market, because of the high levels of credit risk. Investors in the high yield market are often more specialized, because they must have better data and analytics to accurately measure the probability of default. As they say, “one man’s trash is another man’s treasure.” The high yield bond market can provide much higher returns to investors if the investor can successfully manage the credit risk.
A bond rating can change after origination. If the credit rating is increased, it is a credit rating upgrade. If the credit rating is decreased, it is a credit rating downgrade. A change typically occurs to a deterioration in firm quality, so downgrades are much more common than upgrades. When a bond is downgraded, this signals a reduction in the likelihood of repayment. Demand for the bond will decline, causing price to decline and yield to maturity to increase.
Risk Premium and the Business Cycle
The difference in yield between high credit risk bonds and low credit risk bonds is called the risk premium. As noted earlier, bonds with high credit risk have high yields and bonds with low credit risk have low yields. Therefore, the risk premium can be calculated as the difference between the two. It is a “spread” (yield differential) between high risk and low risk bonds.
There are different ways to measure the risk premium, just like there are different ways to measure the term premium. One approach is to use Treasuries as the risk-free rate at a given maturity. This would be the low credit risk yield. The higher-risk yield can be measured using bonds at the bottom of the investment grade spectrum (e.g., Baa). Therefore, one measure of the risk premium is “Baa – Aaa” yield difference on bonds.
In an economic downturn, corporate earnings typically fall. This means that credit risk increases in economic downturns. Defaults are at their highest during economic recessions. As a result, this is also when the risk premium is at its highest. In other words, the risk premium tends to “widen” during a recession. A rising risk premium is a sign of concerns about rising credit risk. In contrast, in an expanding economy, credit risk is declining. The risk premium tends to “narrow” during an economic boom.
To illustrate this, consider the following chart:
This chart shows the 10-year treasury yield (in blue), which is one of the benchmark sovereign yields for the corporate bond market. This is the risk-free rate. Above that line are the Moody’s Aaa corporate bond yield (in red) and the Moody’s Baa corporate bond yield (in green). The two corporate yields track closely with one another. However, in periods of economic expansion, the spread (or gap) between Aaa and Baa tends to narrow. This can be seen in the period between 2001 and 2008-2009 recessions. In the 2008-2009 recession, this spread then widened significantly. This illustrates how the risk premium increases in a recession and then declines in a recovery.
You can understand this also as a “risk rotation.” Investors rotate out of risky bonds (Baa) and into safer bonds (Aaa or Treasuries). Demand for Baa falls, which pushes price down and yield up. Demand for Treasures rises, which pushes price up and yield down. This risk rotation causes the risk premium to increase.
Just as with interest rate risk, timing is everything. A bond investor will make money if aggregate rates fall. This is the positive side of interest rate risk. In corporate bonds, an investor can also make money in risky bonds if the risk premium falls. An investor in risky bonds will see significant price appreciation when the economy recovers and demand rotates back into risk bonds. This is how bond investors make money from changes in the risk premium.
Investing in Corporate Bonds
Bond investing has changed over the years. Bill Gross, a co-founder of PIMCO, was known as the “Bond King” when he ran PIMCO’s Total Return Fund. This was the largest bond fund prior to Gross leaving PIMCO to join Janus in 2014. Now, the three largest bond funds are managed by Vanguard. The largest is Vanguard Total Bond Market Index Fund (VBMFX). The fund is an index fund that tracks the Bloomberg Barclays U.S. Aggregate Float Adjusted Index.
Although it is possible to buy individual corporate bonds through a full-service broker, many retail investors invest in bonds using bond mutual funds or exchange-traded funds (ETFs). An ETF trades on an exchange, but can be invested in any type of financial asset.
Here is a list of the 10 largest bond ETFs. AGG is an iShares ETF that also tracks the Bloomberg Barclays US Aggregate Bond Index.
Like bond prices, bond ETF prices are closely related to interest rates. Bond ETFs have interest rate risk, which will cause their value to rise in a falling rate environment and fall in a rising rate environment.