YBFAs part 2
Corporate Fixed Income and their
ratings
ti
...
(c) 2000-2013 Gary R. Evans. May be used only for non-profit educational use without permission of the author.
Types of Risk Embodied in the Yields of YBFAs
• Market risk (which we have already seen)
– due to capital gains and losses when interest rates fluctuate
– the longer the maturity, the higher the risk
... and these overlap a lot.
– common to all YBFAs, including Treasuries
A rise in credit risk made
• Default risk
– reflected in corporate and municipal YBFAs
– not present in Treasuries
evident by a ratings
downgrade will also raise
default risk and possibly
market risk.
• Credit risk
– risk that the underlying agency,
agency government,
government or corporation that
has issued the YBFA experiences a downgrade
• Economic risk
– due to inflation or similar economic or political shocks
– Treasuries may experience "flight to safety" during political
shocks.
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Corporate Bonds and Notes (CBNs)
•
•
•
•
Major funding source for corporations
Thousands of listings at every maturity
Unlikee Treasuries,
U
easu es, CBNs
C Ns also
a so subject to de
default
au t risk
s
Hence, CBNs are risk-rated by credit agencies
– primarily Moody's, Standard and Poors, and Fitch
• Ratings and changes in ratings have a large impact upon
yields
• Even the highest-rated CBNs have higher yields than
Treasuries of equivalent maturities.
maturities
• This is a playground only for professionals, except maybe
ETFs
• Diversified CBN mutual funds, however, can be a nice
supplement to a balanced mutual fund portfolio.
Corporate
Bond Ratings
for Risk
Because of the possibility
of default, corporate,
municipal, and international
bonds are rated for risk by
agencies like Standard and
Poors. Shown here are the
ratings grades. The lower
the rating the higher the risk
and the higher the effective
yield, which may be
represented by a deep
discount in the bond price.
Source: www.bondsonline.com
Moody's
S&P
Fitch
Aaa
Aa1
Aa2
Aa3
A1
A2
A3
Baa1
Baa2
Baa3
Ba1
Ba2
Ba3
B1
B2
B3
Caa1
Caa2
Caa3
Ca
C
-
AAA
AA+
AA
AAA+
A
ABBB+
BBB
BBBBB+
BB
BBB+
B
B
BCCC+
CCC
CCC-
AAA
AA+
AA
AAA+
A
ABBB+
BBB
BBBBB+
BB
BBB+
B
B
BCCC
DDD
Definitions
Prime. Maximum Safety
High Grade High Quality
Upper Medium Grade
Lower Medium Grade
Investment grade
Non Investment Grade
Speculative
Highly Speculative
Substantial Risk
In Poor Standing
Extremely Speculative
May be in Default
Default
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Corporate Yield Spreads
June 30, 2004
Reuters Corporate Spreads for Industrials*
Rating
Aaa/AAA
Aa1/AA+
Aa2/AA
Aa3/AAA1/A+
A2/A
A3/ABaa1/BBB+
Baa2/BBB
Baa3/BBBBaa3/BBB
Ba1/BB+
Ba2/BB
Ba3/BBB1/B+
B2/B
B3/BCaa/CCC
1 yr
5
10
15
20
30
40
50
60
65
75
85
290
320
500
525
725
1500
2 yr
10
15
25
30
40
50
65
75
80
90
100
290
395
525
550
800
1600
3 yr
15
20
30
35
45
57
79
90
88
105
115
265
420
600
600
775
1550
5 yr
22
32
37
45
58
65
85
97
95
112
124
240
370
425
500
800
1400
This shows spread above
underlying Treasury
Issue in basis points.
7 yr
27
37
44
53
62
71
82
100
126
116
130
265
320
425
450
750
1300
10 yr
30
40
50
55
65
75
88
107
149
121
133
210
290
375
450
775
1375
30 yr
55
60
65
70
79
90
108
127
175
146
168
235
300
450
725
850
1500
Source: www.bondsonline.com
How default risk impacts bond values
As time passes, these become random variables
with special properties:
n
C
Par
MV  
i 
1  r  n
i  1 1  r 
Each value has an a-priori probability of default, with the
special condition that a fault at times 't' insures default for all
value past that time, plus default of Par. Therefore expected
future cashflow must take this into account.
3
Standard & Poor’s Estimated Average Cumulative
Default Rates for various credit ratings
... showing their
estimates of the
estimated cumulative
default rate (e
(e.g.
g the
estimate of a CCC/C
junk bond defaulting
within 2 years is above
30%, within 7 years is
above 45%).
Source: Standard and
Poor’s Global Fixed
Income Research, “The
Time Dimension of
Standard & Poor’s Credit
Ratings,” September 22,
2101, p.3 Chart 1.
Standard & Poor’s Credit Ratings of General
Motors, Lehman Brothers, and WaMu:
Source: Standard and Poor’s Global Fixed Income
Research, “The Time Dimension of Standard & Poor’s
Credit Ratings,” September 22, 2101, p.6 Chart 4,5.
4
Standard & Poor’s scenario of the impact
of economic risk upon default rates:
This is “idealized,”
meaning mostly
conceptual but still
loosely valid. You
cannot estimate
cardinal
probabilities for
events like this.
Source: Standard and
Poor’s Global Fixed
Income Research, “The
Time Dimension of
Standard & Poor’s Credit
Ratings,” September 22,
2101, p.14 Chart 9.
Composite yields of AAA, BBB, and CCC rated bonds
Jan 2, 1997 – October 21, 2011, daily
50
45
40
35
30
25
20
15
10
5
0
AAA
BBB
CCC
Source: FRED Economic Data, Federal Reserve Bank of St. Louis, BofA Merrill Lynch Effective Yield for the
three yields shown.
5
Composite spreads between of AAA, BBB, and CCC
rated bonds and Treasuries
Jan 2, 1997 – October 21, 2011, daily
50
45
40
35
30
25
20
15
10
5
0
AAA
BBB
CCC
Source: FRED Economic Data, Federal Reserve Bank of St. Louis, BofA Merrill Lynch Option Adjusted spreads
for the three ratings shown.
Spread between investment grade AAA and USTs
Jan 2, 1997 – October 21, 2011, daily
7
6
5
4
3
2
1
0
Source: FRED Economic Data, Federal Reserve Bank of St. Louis, BofA Merrill Lynch Option-Adjusted AAA
Spread.
6
Investment Grade and BBB rated bonds
various maturities, November 4, 2013
Same data
2012
2011
Source: bondsonline.com
Select Fixed Income ETFs
Most fixed-income ETFs distribute “dividends” that reflect interest earned, so their
NAV reflects market value discount or premium from par.
PIMCO Investment
Grade Corporate
Bond Index - CORP
For a sample of the kind of
info you get from research
into a FI ETF:
http://www.pimcoetfs.com/Funds/Pages/CORP.aspx
SPDR Barclays High
Yield Bond - JNK
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Municipal Bonds
• Issued by state and local governments, or agencies
of these.
• Two types
– General obligation (State of California)
– Agency (School district_
– Revenue bonds (secured by revenues or taxes)
• Tax free (many restrictions)
– T
Tax free
f federal
f d l always
l
– Tax free state if resident of state issuing bonds
• Have lower yields reflecting tax free status.
A typical selection of munis ...
Source: Online Wall Street Journal for the date
shown.
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Tax features of bonds and notes
• Generally
– Cap gain from trading taxed in year of sale
– Principal redemption at maturity not taxed
• Treasuries
– Coupon interest is taxed
– but tax-free at state and local level
interest earned on TIPS is not taxed at the state and local level. However,
capital appreciation to the inflation adjustment is taxed each year as normal
income. This, in fact, is reported by the Treasury to the IRS on a 1090-OID.
• Munis
– capital
it l gains
i always
l
taxed
t d
– interest income not taxed at federal level
– .. nor state level if issued in state of residence
• Corporate
– all interest and cap gains taxable
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