Question

Aproposed corporate bond issue is usually subjected to a credit risk assessement by credit rating agencies. The results of such an assessement provide a basis for potential investors to make decisions regarding the proposal.

Some investors consider duration to be useful factor when deciding whether to invest in corporate bonds. however ,other investors do not consider duration to be that useful and as such,they rely solely on the work work of credit rating agencies. Such investors consider the information provided by the credit rating agencies to be more useful than duration when choosing the bonds to invest in.

Required

Prepare a report that covers the following

a) A discussion of the factors that contribute to the credit risk and an explaination of the relationship between credit risk and interest rate risk

b) Identification and explanation of any two(2) approches that may be used to assess the degree of credit risk of a proposed bond issue

c) A critical discussion of the usefulness of duration as a measure of interest rate risk relating to the corpoate bonds

d) An evaluation whether there is a relationship between using duration and credit ratings when choosing bonds that an investor should invest in.

Answer 1

A) Credit risk is essentially the risk associated with the ability of a borrower to make timely payments of interest and principal on the debt that has been borrowed. On the other hand, interest rate risk deals with the risk associated with the change in value of a bond when interest rates change. Bonds and interest rates are inversely proportional to each other. If the interest rates fall, the value of a bond goes up. Conversely, if the rates rise, there will be a decline in value of the bond. It is this uncertainty in the value of the bond that leads to interest rate risk.

The factors that contribute to credit risk are as follows:

1) Capacity: An analysis of capacity deals with analysing the ability of a borrower to make timely payments of interest and principal. Essentially, it involves an assessment of the health of the company and the structure of the Industry.

2) Collateral: This is a crucial part of credit analysis especially for issuers who are deemed to be less credit worthy. It involves an analysis of the proportion of intangible assets a company has on its balance sheet, human capital, market capitalisation of a company and analysis of depreciation expenses relative to CAPEX.

3) Covenants: Every bond issue has certain covenants associated with it. They are meant to protect the debt holders against certain actions that the company can take, which could be detrimental to the debt holders. Covenants are essentially of two types: affirmative and Negative. A careful analysis of both the types of covenants is ideal in credit analysis.

4) Character: Although character is relatively hard to assess, it is one of the most important things to be kept in mind. Management that has a strong character and an ethical reputation will be less likely to default on a loan.

B) Credit risk comprises of two fundamental components. A careful analysis of each of them, would give an analyst greater insight into the credit risk associated with a bond issue.

1) Default Risk: Default risk can be defined as the probability that an issuer will fail to pay interest or principal on a given bond issue.

2) Loss Severity: This is also known as loss given default. Is is a hypothetical value that will be lost if the issuer defaults on a bond. Is is generally stated as a percentage of a bond's value.

Now, the default risk can be calculated by using various statistical techniques. As a matter of fact, certain regimes have even made it mandatory to disclose the probability of default within a bond Indenture. On the other hand, loss severity can be assessed by conducting a careful analysis of the collateral.

Finally, one can easily calculate the expected loss in a bond issue by multiplying the default risk with the loss severity.

C) Technically, Duration can be defined as the sensitivity of a bond's value to a change in its yield. If we were to analyse the interest rate risk of a bond, we would observe that the longer the maturity of a bond, the higher will be its sensitivity to changes in interest rates. Further, the lower the coupon rate, the higher will be a bond's sensitivity with interest rates.

Duration can be described as the period that an Investor will have to hold a bond so that reinvestment risk is exactly offset by market price risk. If an investor is concerned with changes in the value of his bond, he would be better of holding bonds with a lower duration. On there other hand, investors that are concerned with the reinvestment risk should hold bonds with longer duration.

Furthermore, a more useful measure known as Modified Duration can give Investors greater insights when analysing bond issues. Modified Duration can be calculated as Maculay Duration divided by one plus the bonds yield to maturity. It can be interpreted as the % change in bond value for a 1% change in yield to maturity.

D) Both credit rating and duration are crucial pieces of information for any bond Investors. While credit ratings give a holistic view of the risk's associated with a bond issue, Duration specifically address its interest rate risk. A duration of a bond cannot be analysed like a credit rating. While bonds with higher credit ratings can be considered safer bets as compared to bonds with lower credit ratings, it is not necessary that a an investor will be better off if he choses a bond with a higher duration. In fact, bonds with higher duration are more volatile as compared to bonds with lower duration. Ideally, if the interest rates are expected to be lowered in the future, the investor should be into bonds with higher duration. On the other hand, if the interest rates are expected to increase, the investor will be better off in a bond with a lower duration.