Academic Year 2019-20
Sem-II
Study Project Econ F366
A Study on Investment in
Corporate Bonds
By :
Neeraj Sonawane
2017A3PS0433G
Supervised by:
Prof. Rammohan Menon
The following study project is in compliance with the course econ F366 under Prof. Rammohan
Menon at Birla Institute of Technology and Science, K K Birla Goa Campus. I would thank Prof.
Rammohan Menon for all his help in preparing the project. The content presented is used for
educational purposes only and is recognized in the references.
Outline
Abstract
Introduction
An Overview
Types of Corporate bonds
Introduction to Credit Risk
Returns
House of Debt
China’s high and rising corporate rate
Fear and Virus spreads
Case Study
Conclusion
Acknowledgment
References
Abstract
For any business to grow it needs capital, maybe labor or economic
capital. We will discuss the economic capital in this project. There are primarily
two financial instruments i.e. equity and debt. These financial instruments play
a crucial role for raising capital for businesses. For any country, there is always
a need for a liquid bond market with a sizeable corporate bond market. This
debt is funded through bond issuances and bank loans. A liquid bond market
helps businesses and corporations to raise funds a relatively cheaper cost than
raising money through banks. This project illustrates different aspects of the
corporate bond market in the US using well-published data.
Introduction
For decades, corporations across countries have leveraged their capital
structure by raise debt or some form of borrowing money. Debt is the primary
means of raising long-term capital in businesses across the globe. Although the
equity market has seen significant growth, the need for a liquid bond market
with a sizeable corporate bond market is very much important for a developed
or emerging country. As of 2018 in the US, there are 8000+ companies listed
across 10 exchanges and the market cap for just S&P 500 is over $10T.
Therefore there is a need for developing the corporate bond market as an
alternative funding source.
The project has been divided into 5 parts as follows:
 Types of Corporate bonds
 Introduction to Credit Risk
 Returns
 How debt brings risk to an economy?
 Case study
Review of Literature - An Overview
Corporate bonds have been in use for a very long time dating 17th century. The
first co. to issue corporate bond was Dutch East India Co. in 1763. Corporate
bonds were issued in large amounts over-the-counter in the US in period of the
1920s. Today by far, the largest market for corporate bonds is in corporate
bonds denominated in US Dollars about $ 9 T in market size. Some of the
corporate bonds have been on exchange as a “listed” bond.
Need for a Developed Market
Corporate bonds are a form of debt instruments used by companies to raise
more capital and meet their goals. The alternative for companies to raise
capital is by selling equity. This is a long and expensive procedure. Selling
bonds, while still complicated, is easier.
Types of Corporate Bonds
Duration: Time taken for the bond to mature.
• Short-term: Bonds that mature in three years or less. These bonds are
considered to be the safest, because they are held for less time
eventually leaving with less risk of change of interest rates and inflation.
• Medium-term: These bonds can vary from 4 to 10 years till maturity.
These bonds are a bit risky as there is a risk of change of corporate
structure of the business as well as change of corporate governance. The
Fed purchases these when they see the need to stimulate the economy
through quantitative easing.
• Long-term: These longer-term bonds, with terms of more than 10
years, offer higher interest rates because they tie up creditor’s money
for a long time. This makes the yield, or overall return, more sensitive to
interest rate movements. The risk associated with these bonds is higher
than the other two.
Interest Payment
• Fixed Rate: Receive the same payment each month until maturity. These
are called coupon payments.
• Floating Rate bond: Reset their payments periodically, every six months.
• Zero Coupon bond: Withhold interest payments until maturity.
• Convertible bond: These allow you to convert them to shares of stock. A
good option of investment as you are protected as a lender.
Risk
• Investment Grade bond: These are issued by companies that are
unlikely to default. These corporate bonds are really still quite safe.
These are rated at least Baa3 by Moody’s and at least BBB- by Standard
& Poor’s and Fitch Ratings.
• High-yield bond: Also known as junk bonds, offer the highest return. But
they are the riskiest. These are considered downright speculative. These
bonds rate a B or lower.
*Fig. Bond Rating
S&P 500® BBB Investment Grade Corporate Bond Index
The S&P 500® BBB Rated Corporate Bond Index, a sub-index of the S&P 500
Bond Index, measures the performance of U.S. corporate debt issued by
constituents in the S&P 500 rated 'BBB’. The S&P 500 Bond Index is designed in
similar manner with the S&P 500 using the weighted average of outstanding
corporate bonds and is regarded as the best single gauge of corporate debts.
Inflation
Imagine, that you buy a U.S. Treasury bond that pays 3 %. Taking in
consideration the stability of the U.S. government, that is considered to be the
safest heaven in times of crisis… unless the rate of inflation rises to, say, 4 %.
You will get your principal back when the bond matures, of course, but it will
be of no worth – its buying power will have declined. In 1981, The Treasury
Department started selling bonds called Treasury Inflation-Protected
Securities (TIPS). The principal value of TIPS scales based on inflation as
measured by the Consumer Price Index (CPI). The rate of return investors
receive reflects the adjusted principal.
*Fig. Annualized return from US TIPS
Analysis - Introduction to Credit Risk
Corporate bonds have almost always higher interest rates than government TBonds as they are considered to have a higher risk, even for companies with
top-flight credit quality. Most corporate bonds are debentures, that is they are
not secured by any security/collateral. Investors in 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.
Assessing Credit Risk
Two ways of analyzing and assessing credit risk are interest-coverage ratios
and capitalization ratios.
Interest-coverage ratios: The interest coverage ratio is a debt ratio used to
determine how easily a company can pay interest on its outstanding debt. E.g.
standard interest-coverage ratio is EBIT / annual interest expense.
Capitalization ratios: Capitalization ratios measure the proportion of debt in a
company’s capital structure, i.e. Debt by firm value. This ratio, calculated as
long-term debt divided by total assets, analyzes the degree of financial
leverage.
Credit Spread: The Payoff for Assuming
Credit Risk in Corporate Bonds
The difference between the yield on a corporate bond and a government bond
is called the credit spread. The payoff for assuming all these additional risks is a
higher yield.
*Fig. Yield curve for different time frames & ratings
Returns
• Historical Performance post-2008
Credit Suisse High Yield Index (DHY) & S&P 500 Investment Grade Corporate Bond Index
The below chart shows Investment Grade and HY corporate bonds valuations
of US and Asian (China) amidst the US-China trade tension. Whereas, EM IG
show better yields at the cost of BAA credit rating.
What changed after Financial crisis 2008 ?
The Risk-free rate that central bankers call r* fell to levels never seen before
(r*= 0) in the financial crisis of 2008. Although r* does not represent a bond
that is directly traded, it is one of the most important interest rates as it tells
the risk-freeness of government bonds over which risky assets trade for a
premium. A lower r* makes the risky asset look a good investment and might
make it harder for central bankers to conduct monetary policy. In order to
boost the economy, it becomes harder to cut rates as they are low. A lower r*
means lower interest rates on all bonds, and this can have a negative impact
on the economy.
Inferences - House of Debt
The corporate debt bubble is the substantial increase in corporate bonds,
excluding that of financial institutions, following the financial crisis of 2007–08.
The total U.S. corporate debt in November 2019 reached a record 47% of the
entire U.S. economy. The value of total outstanding Chinese non-financial
corporate bonds increased from $69 billion in 2007 to $2 trillion in 2017. In
December 2019, Moody's Analytics described Chinese corporate debt as the
"biggest threat" to the global economy. The McKinsey Global Institute also
stated in 2018 that the greatest risks would be to emerging markets such as
China, India, and Brazil, where 25-30% of bonds had been issued by high-risk
companies.
Domino Effect
• Low bond yields led to the purchase of riskier bonds.
After the financial crisis of 2007–08, the Federal Reserve Board brought
down the short-term and long-term interest rates to raise market liquidity.
However, the effect of quantitative easing affected not only to the toxic
mortgage bonds targeted by central banks but also effectively reduced the
supply of bonds as a class, causing prices for bonds generally to increase and
bond yields decrease. In June 2018, 22% of outstanding U.S. nonfinancial
corporate debt was rated junk, and a further 40% was rated one step above
junk at BBB. Hence, approximately two-thirds of all corporate debt was from
companies at the highest risk of default.
• Low-interest rates led to increasingly leveraged companies.
By March 2020, one-sixth of all publicly-traded companies in the U.S. did
not make enough profit to cover the interest on their issued debt. (Ref. Covid19 slowdown) Corporations in the US have started the practice of financing
share buybacks, dividends, and mergers & acquisitions to boost share price
using the debt. This has been done instead of making long-term business
investments and expansions.
• Search for yield results in growth in covenant light bonds.
Most leveraged corporate bonds are called cov-lite, or covenant light,
which do not contain the usual protections for the bondholders. By mid-2018,
77.4% of U.S. leveraged corporate loans were cov-lite.
China's high and rising corporate debt
China’s corporate debt to GDP ratio, a measure of corporate leverage, is now
among the very highest globally. It has risen nearly 65 % within a decade, the
fastest increase among the major economies. Relative to other large
economies, China’s corporate debt burden is unusually large, while its
government debt load appears modest.
IMF staff economists warned in a 2018 working paper that China’s huge credit
boom is on a dangerous trajectory, unsustainable, and presents increasing risks
of a disruptive adjustment and steep growth slowdown over the longer term.
*Fig. Total debt composition of a country’s economy
The Fear and Virus spreads…
As the coronavirus outbreak spreads, shutting down factories from China to
the US, sending stock markets plunging, people pulling out of stocks and
searching for safe investments such as gold, T- Bills as there is fear of global
recession; historic levels of corporate debt threaten to intensify the economic
slump. Companies facing huge debt burdens may be forced to cut costs, laying
off large workforce and scrapping investments, as they seek to avoid default.
The International Monetary Fund published a recent financial stability report
suggesting that, among eight major economies (including the U.S.) holding a
total of $51 trillion in corporate debt, $19 trillion of this debt is at risk of
default. Like the U.S., much European corporate debt is graded BBB, with
almost 40% of BBB debt maturing by the end of next year.
Energy companies find themselves caught in the middle of an oil price war
between Saudi Arabia, Russia, and the United States, and many are expected
to file for bankruptcy.
Case Study - RJR Nabisco LBO
• In 1988, Kohlberg Kravis Roberts & Co. decided to takeover RJR Nabisco
in what was at the time the largest leveraged buyout in history.
• Announcements of successful leveraged buyouts (LBOs) in April 1989
caused a significantly negative return on outstanding publicly-traded
nonconvertible bonds.
• The successful LBO made by KKR ($109/share) led to a change in capital
structure and expected to downgrade in debt ratings for the bonds.
• This left bondholder unprotected and is an example of corporate and
executive greed.
*Fig. 30- year Bond price
Kraft-Heinz: A Berkshire Hathaway
Holding
• In February 2019, shares in Kraft Heinz fell to a record low of under $35,
after the company reported a $10.2bn loss for the previous year as the
company announced that it would take a $15.4 billion write-down of its
Kraft and Oscar Meyer brands, slashing its dividend, and acknowledged
that the U.S. SEC had opened an investigation into its accounting
practices.
• Kraft Heinz had its credit rating downgraded to BBB- or junk in 2020 due
to expected low earnings and the firm's determination to use available
capital to provide stock dividends than to pay the debt.
• Kraft Heinz has only $2.3 billion in cash while $22.9 billion in total debt
with assets to lenders at greater risk.
• The future of KHC is its management and as of April 2020, a new
experienced management should try to bring debt to EBITDA around 4x.
Conclusion
Most investors should choose their risk bearing capacity and make a balance
between risk and return by placing their portfolio in different bond
investments, both investment-grade and high yield. As with stocks, you can do
well by selecting index fund investments if you choose to make a diversified
portfolio. High yield bond funds have for the most part been too risky to
warrant holding them. However, high yield bonds usually pay more interest
than even floating rate bank loan funds. Although no future results would be
guaranteed, it has been possible to earn more than you would have from
investment-grade bond funds by utilizing high yield funds.
*Fig. Shiller explanation of expected reward for certain risk
Acknowledgment
This project was fun to do and a great learning experience. Firstly, I thank my
teacher Prof. Rammohan Menon for give the opportunity to do the project
under his guidance. Secondly, I am grateful to all the publicly available content
with some well know researchers and professors as well as journalists for their
extensive work in their fields. Overall this was a wonderful way of learning new
things.
Data Collection: Publicly available data from
https://www.sifma.org/?aq=&hPP=10&idx=prod_wp_searchable_posts&ap=0
&is_v=1
References
https://www.merics.org/en/china-monitor/chinas-corporate-debt
https://www.ft.com/content/17943d46-62fa-11ea-b3f3-fe4680ea68b5
https://www.cnbc.com/2019/12/17/chinas-corporate-debt-is-biggest-threat-toglobal-economy-moodys.html
https://www.sifma.org/?aq=corporate&hPP=10&idx=prod_wp_searchable_post
s&ap=0&is_v=1
https://us.spindices.com/indices/fixed-income/sp-500-bbb-investment-gradecorporate-bond-index
https://www.spglobal.com/en/research-insights/articles/u-s-corporate-debtmarket-the-state-of-play-in-2019
https://www.thebalance.com/high-yield-bonds-historical-performance-data417116
https://qz.com/1750949/how-the-financial-crisis-changed-markets/
https://www.thebalance.com/stocks-vs-bonds-the-long-term-performance-data416861