Understanding the Risks of Corporate Bonds
Interest Rate Risk. Like all bonds, the price of corporates rises when interest rates fall, and fall when interest rates rise. Generally speaking, the longer a bond’s maturity, the greater the degree of price volatility. An investor holding a bond until maturity may be less concerned about these price fluctuations (which are known as interest-rate risk, or market risk), because he or she will receive the par, or face, value of the bond at maturity.
Investors should be aware of the inverse relationship between bond prices and interest rates — that is, the fact that bonds are worth less when interest rates rise. But the explanation is essentially straightforward:
- When interest rates rise, new issues come to market with higher coupon rates than older securities, making those older ones less attractive in comparison. Hence, their prices go down.
- When interest rates decline, new bond issues come to market with lower coupons than older securities, making those older, higher coupon bonds more attractive. Hence, their prices go up.
As a result, if an investor sells a bond before maturity, it may be worth more or less than at the time of purchase.
Various economic forces affect the level and direction of interest rates in the economy. Interest rates typically climb when the economy is growing, and fall during economic downturns. Inflation is one of the most influential forces on interest rates; rising inflation leads to rising interest rates, and moderating inflation leads to lower interest rates.
- Call features. A bond’s indenture (the legal document that spells out its terms and conditions) may contain a “call” feature. This provision gives the bond issuer the right to retire, or redeem, the bond, fully or partially, before the scheduled maturity date. For the issuer, the chief benefit of such a feature is that it may permit the issuer to replace outstanding debt with a lower coupon rate new issue if interest rates decline in the future.
- A call feature creates uncertainty for the investor as to whether the bond will remain outstanding until its maturity date, especially in the case of a high coupon bond in a falling interest rate environment. Investors risk losing a bond paying a higher rate of interest when rates decline because the issuer may decide to call in their bonds. When a bond is called, the investor usually can only reinvest in securities with lower yields. Calls also tend to limit a bond’s price 10 appreciation potential as the call risk increases at the same time as the price would be expected to rise.
- Because a call feature puts the investor at a disadvantage, callable bonds carry higher yields than non-callable bonds, but higher yield alone is often not enough to induce investors to buy them. As further inducement, the issuer often sets the call price, the price investors must be paid if their bonds are called, higher than the principal value of the issue. The difference between the call price and principal is the call premium.
- Generally, bondholders do have some protection against calls, and the right to call may be limited.
- Sinking-fund provisions. A sinking fund is money taken from a corporation’s earnings that is used to redeem bonds periodically, before maturity, as specified in the indenture. If a bond issue has a sinking-fund provision, a certain portion of the issue must be retired each year. The bonds retired are usually selected by lottery.
- One investor benefit of a sinking fund is that it lowers the risk of default by reducing the amount of the corporation’s outstanding debt over time. Another is that the fund provides price support to the issue, particularly in a period of rising interest rates. However, the disadvantage is that bondholders may receive a sinkingfund call at a price (often par) that may be lower than the current market price.
- Other types of redemptions. Bond investors should be aware of the possibility of certain other kinds of calls or redemptions prior to maturity. Some bonds, especially utility securities, may be called under what are known as Maintenance and Replacement fund provisions (which relate to upgrading plant and equipment). Others may be called under Release and Substitution clauses (which are designed to maintain the integrity of assets pledged as collateral for some bonds) and Eminent Domain clauses (which have to do with paying off bonds when a governmental body confiscates or otherwise takes assets of the issuer).
- Redemption risks may be avoided by buying only non-callable bonds without sinking-fund provisions. When evaluating investment in callable bonds, investors should consider the yield to call rather than the yield to maturity.
- Puts. Just as some issuers have the right to call their bonds prior to maturity, some bonds include a provision granting investors the option to “put,” or redeem, the bond prior to maturity. At specified intervals, investors may “put” the bond back to the issuer for full face value plus accrued interest. In exchange for this privilege, such bonds have a somewhat lower yield than a comparable bond without a put feature.
Credit risk. Credit risk is the potential for loss resulting from an actual or perceived deterioration in the financial health of the issuing company. Two subcategories of credit risk are default risk and downgrade risk.
- Default Risk. Defaults occur when a company fails to pay an interest or principal payment to a debt holder as scheduled and as specified in its indenture. The risk of default on principal or interest, or both, is greater for high-yield bonds than for investment-grade bonds. Factors that may lead to default include business cycle volatility, excessive leverage or threats from competitors. In a corporate bankruptcy or dissolution, although secured bondholders and holders of senior debt issues may receive some distribution of corporate assets, it is rarely enough to “make whole” their total investment. Bonds of companies in default may trade at very low prices, if they trade at all, and liquidity may disappear.
- Downgrade risk. Downgrades result when a rating agency lowers its rating on a bond or the company that issued a bond; for example, a change by Standard & Poor’s from a B to a CCC rating. Downgrades are usually accompanied by bond price declines. In some cases, the market anticipates downgrades by bidding down prices prior to the actual rating agency announcement. Before bonds are downgraded, agencies often place them on a “creditwatch” status, which also tends to cause price declines.
Liquidity risk. Liquidity risk refers to the investor’s ability to sell a bond quickly and easily, as reflected in the size of the bid-ask spread, or the difference between the price at which buyers are willing to buy (the bid) and the price at which sellers are willing to sell (the ask) a bond. That spread is usually quite small for large, actively traded bond issues, reflecting ample liquidity. A wider spread indicates, among other things, greater liquidity risk. High-yield bonds may be less liquid than investment-grade bonds, depending on the issuer and the market conditions at any given time.
Economic risk. Economic risk describes the vulnerability of a bond to downturns in the economy. Virtually all types of high-yield bonds are vulnerable to economic risk. In recessions, high-yield bond prices typically fall more than investment-grade bonds, a reflection of their credit quality. When investors grow anxious about holding lower credit quality bonds, they may trade them for the higher-quality debt, such as U.S. Treasuries and investment-grade corporate bonds. This “flight to quality” particularly impacts high-yield issuers.
Company and industry “event” risk. Event risk encompasses a variety of pitfalls that can affect a company’s ability to repay its debt obligations on time. These may include poor management, changes in management, failure to anticipate shifts in the company’s markets, rising costs of raw materials, regulation and new competition. Events that adversely affect a whole industry can have a blanket effect on all the bonds in that sector.