Investment-grade bonds

The greater the expected yield volatility, the greater the interest rate risk for a given duration and current value of a position. In the case of non-investment grade bonds, while their durations are less than current coupon Treasuries of the same maturity, the yield volatility is greater than that of current coupon Treasuries. For the 10-year Swiss government bond, while the duration is greater than for a current coupon 10-year US Treasury note, the yield volatility is considerably less than that of 10-year US Treasury notes. 

Interest rate or term structure risk stems from movements in the benchmark interest rate curve. Excluding exchange rate risk, it is the main source of risk for most investment-grade bonds. Any reasonable model will include markets that are stable and actively traded. A typical coverage, taken from JP Morgan GBI Broad Index, is shown in Exhibit 23.1. Note the presence of two emerging markets. 

Fallen angels are securities that started out as investment grade bonds and have ended up, or are expected to end up in high-yield territory, such as Marconi and KPN. The former rose substantially before the downgrade to high yield, as it formed a big part of the European high-yield index, and high-yield investors had no choice but to buy the name and bid up the price. 

For fund investors new to the bond market, most advisors would suggest buying a fund dedicated to intermediate-term, investment-grade bonds. They also should commit to hold that fund for at least a few years, if possible. The holding period is what is going to protect investors and provide decent returns over time. 

To assess the impact of changing yield spreads therefore, it is necessary to carry out a simulation on the effect of different yield curve assumptions. For instance, we may wish to analyse 1-year holding period returns on a portfolio of investment-grade corporate bonds, under an assumption of widening yield spreads. This might be an analysis of the effect on portfolio returns if the yield spread for triple-B-rated bonds widened by 20 basis points, in conjunction with a varying government bond yield. This requires an assessment of a different number of scenarios, in order to capture this interest-rate uncertainty. 

For lower- and non-rated bonds, the observed effect is the opposite to that of an investment-grade corporate. Over time the probability of default decreases therefore, the theoretical default spread decreases over time. This means that the spread on a long-dated bond will be lower than that of a short-dated bond because if the issuer has not defaulted on the long-dated bond in the first few years of its existence, it will then be viewed as a lower risk credit, although the investor may well continue to earn the same yield spread. 

The research compares the model spread to the one observed in the market. In order to determine the term structure of credit spread. Eons uses historical probabilities by Moody s database, adopting a recovery rate of 48.38%. The empirical evidence is that bonds with high investment grade have an upward credit spread curve. Therefore, the spread between defaultable and default-free bonds increases as maturity increases. Conversely, speculative-grade bonds have a negative or flat credit yield curve (Figure 8.7). 

FIGURE 8.7 The term structure of credit spread for investment- and speculative-grade bonds. 

The treatment of unrated paper for investment grade indices falls under this category. Many index providers include unrated paper in investment grade indices on the premise that if these instruments were to be rated they would end up in the investment grade. The other area where many index providers often vary from each other is the treatment of splitrated bonds, both for the rating tier they represent, as well as to determine whether they form part of the investment grade universe or not. 

Credit-linked notes are hybrid securities, generally issued by an investment-grade entity, that combine a credit derivative with a vanilla bond. Like a vanilla bond, a standard CLN has a fixed maturity structure and pays regular coupons. Unlike bonds, all CLNs, standard or not, link then-returns to an underlying asset s credit-related performance, as well as to the performance of the issuing entity. The issuer, for instance, is usually permitted to decrease the principal amount if a credit event occurs. Say a credit card issuer wants to fond its credit card loan portfolio by issuing debt. To reduce its credit risk, it floats a 2-year credit-linked note. The note has a face value of 100 and pays a coupon of 7.50 percent, which is 200 basis points above the 2-year benchmark. If more than 10 percent of its cardholders are delinquent in making payments, however, the note s redemption payment will be reduced to 85 for every 100 of face value. The credit card issuer has in effect purchased a credit option that lowers its liability should it suffer a specified credit event—in this case, an above-expected incidence of bad debts. 

Total Issuance High Yield Loans Structured Finance Other - Includes Investment Grade, HY Bonds, Other Oollateral... 

Corporate bonds fall into two broad credit classifications investment-grade and high-yield (or "junk") bonds. The largest holders of corporate bonds are institutions,- the complexity as well as the fact that corporate bonds are fully taxable at all levels (federal, state, and local) usually makes individual investors shy away. 

To simplify, corporate bonds fall into two broad credit classifications investment-grade and high-yield. 

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