BKM14 - 2 Flashcards
Credit risk
Investment grade
Speculative grade/junk bonds
Credit risk: bond default risk; measured by firms such as Moody’s, Standard & Poor’s, and Fitch
Investment grade: bonds rated BBB or above
Speculative grade/junk bonds: lower rated bonds
determinants of bond safety
coverage ratio
liquidity ratio
leverage ratio
cash flow to debt ratio
profitability ratio
coverage ratio
Ratio of company earnings to fixed costs.
*low/falling ratios may signify possible cash flow difficulties
Times interest earned ratio = earnings before interest payments and taxes / interest obligations
Fixed charge coverage ratio = earnings/all fixed cash obligations
Include lease payments, sinking fund payments, and interest obligations
Leverage ratio
Leverage ratio = Ratio of debt to equity
-if too high, firm may be unable to satisfy its obligations
Liquidity ratios
measures the insurer’s ability to pay bills with its most liquid assets.
Current ratio = current assets / current liabilities
Quick ratio = current assets excluding inventories / current liabilities
Profitability ratios
Return on assets = earnings before interest & taxes / total assets
Return on equity = net income / equity
Cash flow to debt ratio
Cash flow to debt ratio = total cash flow / outstanding debt
due to default risk, stated yield
is maximum possible yield to maturity that the bondholder can earn
- if the financial condition of a firm deteriorates and it becomes likelier that the bonds will default, bond price should fall, resulting in an increase to promised yield to maturity for someone who purchases the bond today
- on other hand, expected yield to maturity should be much less affected
bonds need to offer a
bonds need to offer a default premium to compensate for the chance of default
Default premium
difference between yield of corporate bond and yield of comparable government bond which has no credit risk
credit default swap
essentially an insurance policy on the default risk of a bond/ loan
- CDS buyer needs to pay the seller an annual premium
- seller will compensate buyer in event of default
- CDS typically would be purchased by large bondholders
- investor who holds a bond with BB rating can purchase CDS on issuer to effectively raise the position to that of holding an AAA rated bond
CDS played large role in
2008 financial crisis
-when subprime mortgage market collapsed, obligation on these CDS’ increased to an unimaginable level
Collateralized debt obligation (CDO)
tool that can reallocate credit risk
A financial institution would create a separate entity to buy a portfolio of bonds/ loans. These are pooled together, and then split into different tranches.
- As the securities in the pool make their interest payments, the proceeds are distributed to pay interest to tranches in order of seniority.
- Lower seniority tranches would suffer default losses before higher seniority.
Bond Indentures
- Contract between the bond issuer & bondholder.
- Includes protective covenants that protect the rights of the bondholders.
protective covenants
sinking funds
serial issue
subordination of further debt
dividend restrictions
collateral
sinking funds
the issuer needs to establish a sinking fund to spread burden of repaying principal over several years:
Option 1: repurchase % of outstanding bonds in the open market annually
Option 2: purchase a fraction of the bonds at either the market price or the sinking fund price
2 main difference between a sinking fund call and conventional bond call:
- firm can only repurchase a limited fraction of bonds at the sinking fund call price
- call price of callable bonds usually exceeds par value whereas sinking fund call price is usually set at par value
- sinking funds are designed to protect the bondholders but can actually hurt them because firm would choose to buy back discount bonds at the market price but would buy back the premium bonds at par
Serial bond issue
type of bond issue that does not require sinking fund in which firm issues bonds with staggered maturity dates
- sinking fund is not as necessary because the repayment burden is spread
- main disadvantage is that bonds with different maturities are not interchangeable thus reducing liquidity of issue
Subordination of Further Debt
restricts the amount of additional borrowing and requires additional debt may be subordinate in priority to existing debt
problem with subordination clause
- perhaps the issuer would really need cash, but due to this clause, it will not be able to borrow any additional money. This lack of cash flow could cause it to go into bankruptcy, in which case the bondholder would lose financially
Dividend Restrictions
limit the dividends that the firm can pay.
what bonds are unsecured?
General debenture bonds
- more credit risk, level of which depends on earning power of insurer
- due to higher credit risk, these bonds have to offer higher yields than collateralized bonds
examples of bonds and associate collateral
Mortgage bond & property
Collateral trust bond & other securities
Equipment obligation bond & equipment
