Corporate Bonds: An Introduction To Credit Risk

By David Harper AAA

Corporate bonds offer a higher yield compared to some other investments, but for a price. Most corporate bonds are debentures, meaning they are not secured by collateral. Investors of such bonds must assume not only interest rate risk but also credit risk, the chance that the corporate issuer will default on its debt obligations. Therefore, it is important that investors of corporate bonds know how to assess credit risk and its potential payoffs: while rising interest rate movements can reduce the value of your bond investment, a default can almost eliminate it. Holders of defaulted bonds can recover some of their principal, but it is often pennies on the dollar.

SEE: Tactical Tips For Bond Investors

Review of Yield

By yield, we mean yield to maturity, which is the total yield resulting from all coupon payments and any gains from a "built-in" price appreciation. The current yield is the portion generated by coupon payments, which are usually paid twice a year, and it accounts for most of the yield generated by corporate bonds. For example, if you pay $95 for a bond with a $6 annual coupon ($3 every six months), your current yield is about 6.32% ($6 ÷ $95).

The built-in price appreciation contributing to yield to maturity results from the additional return the investor makes by purchasing the bond at a discount and then holding it to maturity to receive the par value. It is also possible for a corporation to issue a zero-coupon bond, whose current yield is zero and whose yield to maturity is solely a function of the built-in price appreciation.

Investors whose primary concern is a predictable annual income stream look to corporate bonds, whose yields will always exceed government yields. Furthermore, the annual coupons of corporate bonds are more predictable and often higher than the dividends received on common stock.

Assessing Credit Risk
Credit ratings published by Moody's, Standard and Poor's and Fitch are meant to capture and categorize credit risk. However, institutional investors in corporate bonds often supplement these agency ratings with their own credit analysis. Many tools can be used to analyze and assess credit risk, but two traditional metrics are interest-coverage ratios and capitalization ratios.

SEE: What Is A Corporate Credit Rating?

Interest-coverage ratios answer the question, "How much money does the company generate each year in order to fund the annual interest on its debt?" A common interest-coverage ratio is EBIT (earnings before interest and taxes) divided by annual interest expense. Clearly, as a company should generate enough earnings to service its annual debt, this ratio should well exceed 1.0 - and the higher the ratio, the better.

Capitalization ratios answer the question, "How much interest-bearing debt does the company carry in relation to the value of its assets?" This ratio, calculated as long-term debt divided by total assets, assesses the company's degree of financial leverage. This is analogous to dividing the balance on a home mortgage (long-term debt) by the appraised value of the house. A ratio of 1.0 would indicate there is no "equity in the house" and would reflect dangerously high financial leverage. So, the lower the capitalization ratio, the better the company's financial leverage.

Broadly speaking, the investor of a corporate bond is buying extra yield by assuming credit risk. He or she should probably ask, "Is the extra yield worth the risk of default?" or "Am I getting enough extra yield for assuming the default risk?" In general, the greater the credit risk, the less likely it is that you should buy directly into a single corporate bond issue. In the case of junk bonds (i.e. those rated below S&P's BBB), the risk of losing the entire principal is simply too great. Investors seeking high yield can consider the automatic diversification of a high-yield bond fund, which can afford a few defaults while still preserving high yields.

Other Risks
Investors should be aware of some other risk factors affecting corporate bonds. Two of the most important factors are call risk and event risk. If a corporate bond is callable, then the issuing company has the right to purchase (or pay off) the bond after a minimum time period. If you hold a high-yielding bond and prevailing interest rates decline, a company with a call option will want to call the bond in order to issue new bonds at lower interest rates (in effect, to refinance its debt). Not all bonds are callable, but if you buy one that is, it is important to note the terms of the bond. It is important that you be compensated for the call provision with a higher yield.

Event risk is the risk that a corporate transaction, natural disaster or regulatory change will cause an abrupt downgrade in a corporate bond. Event risk tends to vary by industry sector. For example, if the telecom industry happens to be consolidating, then event risk may run high for all bonds in this sector. The risk is that the bondholder's company may purchase another telecom company and possibly increase its debt burden (financial leverage) in the process.

Credit Spread: The Payoff for Assuming Credit Risk
The payoff for assuming all these extra risks is a higher yield. The difference between the yield on a corporate bond and a government bond is called the credit spread (sometimes just called the yield spread).

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As the illustrated yield curves demonstrate, the credit spread is the difference in yield between a corporate bond and a government bond at each point of maturity. As such, the credit spread reflects the extra compensation investors receive for bearing credit risk. Therefore, the total yield on a corporate bond is a function of both the Treasury yield and the credit spread, which is greater for lower-rated bonds. If the bond is callable by the issuing corporation, the credit spread increases more, reflecting the added risk that the bond may be called.

How Changes in the Credit Spread Affect the Bondholder
Predicting changes in a credit spread is difficult because it depends on both the specific corporate issuer and overall bond market conditions. For example, a credit upgrade on a specific corporate bond, say from S&P BBB to A, will narrow the credit spread for that particular bond because the risk of default lessens. If interest rates are unchanged, the total yield on this "upgraded" bond will go down in an amount equal to the narrowing spread, and the price will increase accordingly.

After purchasing a corporate bond, the bondholder will benefit from declining interest rates and from a narrowing of the credit spread, which contributes to a lessening yield to maturity of newly issued bonds. This in turn drives up the price of the bondholder's corporate bond. On the other hand, rising interest rates and a widening of the credit spread work against the bondholder by causing a higher yield to maturity and a lower bond price. Therefore, because narrowing spreads offer less ongoing yield and because any widening of the spread will hurt the price of the bond, investors should be wary of bonds with abnormally narrow credit spreads. Conversely, if the risk is acceptable, corporate bonds with high credit spreads offer the prospect of a narrowing spread, which in turn will create price appreciation.

However, interest rates and credit spreads can move independently. In terms of business cycles, a slowing economy tends to widen credit spreads as companies are more likely to default, and an economy emerging from a recession tends to narrow the spread, as companies are theoretically less likely to default in a growing economy.

In an economy that is growing out of a recession, there is also a possibility for higher interest rates, which would cause Treasury yields to increase. This factor offsets the narrowing credit spread, so the effects of a growing economy could produce either higher or lower total yields on corporate bonds.

The Bottom Line
If the extra yield is affordable from a risk perspective, the corporate bond investor is concerned with future interest rates and the credit spread. Like other bondholders, he or she is generally hoping that interest rates hold steady or, even better, decline. Additionally, he or she generally hopes that the credit spread either remains constant or narrows, but does not widen too much. Because the width of the credit spread is a major determiner of your bond's price, make sure you evaluate whether the spread is too narrow, but also make sure you evaluate the credit risk of companies with wide credit spreads.

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