Question

A proposed corporate bond issue is usually subjected to a credit risk assessment by
credit rating agencies. The results of such an assessment provide a basis for potential
investors to make decisions regarding the proposal.
Some investors consider duration to be a 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 of credit rating agencies. Such investors
consider the information provided by credit rating agencies to be more useful than
duration when choosing the bonds to invest in.
Required:
Prepare a 2,500 word evaluative report that covers the following:
(a) A discussion of the factors that contribute to credit risk and an explanation of the
relationship between credit risk and interest rate risk. [15 Marks]
(b) Identification and explanation of any two (2) approaches that may be used to assess
the degree of credit risk of a proposed bond issue. [10 Marks]
(c) A critical discussion of the usefulness of duration as a measure of interest rate risk
relating to corporate bonds. [15 Marks]
(d) An evaluation whether there is a relationship between using duration and credit
ratings when choosing bonds that an investor should invest in. [10 Marks]
[TOTAL: 50 MARKS]

Answer 1

a) Following are the factors contribute to the credit risk while issuing a corporate bonds:

i) Financial health of issuer through due diligence

ii) Credit Period of corporate bonds

iii) other stability economic factors

iv) comparison with the terms of bonds in economy

v) chances of default of borrower

Both Interest rate risk and credit risk possesses by corporate bonds. Interest Rates risk is measured by the exposure of a bond to changing in prevailing interest rates. Generally, with higher interest rate risk, bonds perform well and vice versa. Whereas, credit risk denotes the exposure to default in the repayment of principal and interest. It completely relies on the financials position of the issuer.

b) Following are the 2 approaches to assess the degree of credit risk:

i) The internally oriented approach

It estimate both the expected cost and volatility of future credit losses based on the firm’s best assessment.

− Future credit losses = Probability that the borrower will default * the portion of the amount lent which will be lost in default.

− Charges for credit losses =(expected probability of default) x (expected percentage loss in event of default)) + risk adjustment x the volatility of ((probability of default x percentage loss in the event of default)

ii) The market -oriented approach

Cost associated with credit risk by the marketplace. It is spread above the risk-free rate on bonds.

c) The higher a bond’s duration, the greater its sensitivity to interest rates changes. That means if you hold a bond to maturity, you can expect to receive the face value of the bond when your principal is repaid. If you sell before maturity, the price you receive will be affected by the prevailing interest rates and duration. The higher level of loss for the longer-term bond happens because its duration number is higher, making it react more dramatically to interest rate changes.

d) There is a direct relationship between using duration and credit ratings when choosing bonds that an investor should invest in. bonds with low coupons have the longest durations. These bonds are more sensitive to a change in market interest rates and thus are more volatile in a changing rate environment. However, bonds with shorter maturity dates or higher coupons will have shorter durations. Bonds with shorter durations are less sensitive to changing rates and thus are less volatile in a changing rate environment.