A Primer on Corporate Bonds – III (Other Risks): Million Dollar Journey

---

A Primer on Corporate Bonds – III (Other Risks) Posted: 22 Sep 2010 04:30 AM PDT This is a guest column by regular contributor Clark. The last article on corporate bonds looked at corporate credit ratings/risk and Part IV dealt with some metrics to remember when purchasing individual bonds. In this part, we'll look at other risks and touch upon the issue of corporate governance. Other Risks Government bonds protect an investor from credit risk, since it is relatively uncommon for countries to go bankrupt when compared to corporations. Corporations offset the additional risk borne by an investor, when holding corporate bonds, by providing better yields than government bonds. Apart from the risk of default and credit risk, there are other risks that an investor would need to be aware of. Liquidity Risk. In the case of individual bonds, there may not be a buyer available when needed, thereby giving grief to the bondholder. Also, the bid-ask spread may be higher than bond ETFs. Call Risk. Certain corporate bonds are issued as callable; these bonds give a company the right to pay off their debt (repurchase the bond) earlier than the maturity date but after a minimum time period. Companies may compensate for this right by offering a higher yield than conventional corporate bonds. Why would a company repurchase their bond? In a market where interest rates have dropped, they would call their bond and re-issue new ones at prevailing lower interest rates. It is a case of taking advantage of market fluctuations and issuing callable bonds gives them the authority to do so. Event Risk. As may be evident from the name, any event such as natural disaster, political instability or change in securities regulations may affect corporate bonds. If such an event triggers an adverse impact to the industrial sector of the corporation, then the ratings agencies may downgrade the company's credit rating. It is not necessary that all companies that have issued bonds in the sector will face the brunt, since some companies may be more financially leveraged than the others. Hence, the individual liability of the business plays a big part in determining the result of the event. Supply Risk. If several bond issues similar to the current one are floated, then the basic supply vs. demand factor may cause a drop in prices. Corporate Governance Ratings No matter how good the balance sheet of a corporation, it wouldn't take long for a poor management team to push the company to the edge of the precipice. Stories of companies going bankrupt due to management malpractices are well-known. To counter such adverse results, corporate governance ratings are published. Company board members may or may not hold these ratings in high regard but they cannot disregard the impact of poor governance ratings. Consistent poor ratings convey to investors that the management is not doing a reasonable job and the board does not want to take action to change the status quo. Prolonged failure to deal with such situations may affect the quality of directors on board, since the good ones may leave if they find too many from the "we don't care" camp and cannot enforce the right measures. Also, in their own self-interest, they will not want to be associated with such companies since it would reflect poorly on their personal credentials and future prospects. Although the issue of corporate governance is important, there seems to be an apparent lack of validity to the ratings issued by the different services as discussed by this study. If you are interested in knowing more about these ratings, check out these Risk Metrics, Standard & Poor's and Corporate Library pages for more and better details. As seen from this three-part series on corporate bonds, there are several factors to be considered before buying an individual bond issue. The presence of credit rating agencies eases the selection process by narrowing the list of companies. Yet, there are other risk factors that need to be considered before becoming an individual bond investor. For investors who lack the time, interest or skill to research bonds, it would be wise to buy a bond fund or bond ETF. They could even go for a higher-yield security, where a few defaults will not entail significant principal loss because of the diversification. About the Author: Clark is a twenty-something Saskatchewan resident employed in the manufacturing sector. He repaid around $20,000 in student loans and has been working to build his investment portfolio as a DIY investor (not trader) while nurturing plans to retire early. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. Popular Posts: The Smith Manoeuvre – A Wealth Strategy – I The Smith Manoeuvre – A Wealth Strategy – II Canadian Discount Brokerage Comparison Top Cash Back Credit Cards in Canada Child Care Tax Credits Are Hybrid Vehicles Worth it? Tax Free Savings Account (TFSA) Copyright 2010 MillionDollarJourney – All Rights Reserved

A Primer on Corporate Bonds – I (Credit Ratings): Million Dollar Journey

---

A Primer on Corporate Bonds – I (Credit Ratings) Posted: 02 Sep 2010 04:30 AM PDT This is a column by regular contributor Clark. The earlier parts of the bond series dealt with the basic types of bonds and their risks and suitability. This part will begin a sub-series on corporate bonds. As mentioned in the first part of the series, corporate bonds are issued by companies to gather funds for their business. With thousands of companies issuing bonds, where does one start to make the list smaller? Credit Rating Agencies Similar to credit reporting bureaus that keep track of a consumer's credit history, there are Nationally (US) Recognized Statistical Rating Organizations such as DBRS (short for Dominion Bond Rating Service), Moody's, Standard and Poor's(the S&P Indices fame) and Fitch Ratings that issue credit ratings for companies. These agencies offer a rating system to aid investors in determining the risks associated with investing in any company. Debt could be secured or unsecured and there are specific ratings for short-term debt, long-term debt, preferred stock, etc. A glance at the long-term credit ratings of a company (that also considers assets or collateral needed in case of default) would show the company's ability to fulfill its debt obligations and credit worthiness. It must be noted that credit ratings are not meant as alerts to buy, hold or sell; they are just a tool to assess a company's capacity to pay back debt. Foreign Currency Debt Companies may borrow from lenders inside and/or outside the country (for example, Canadian companies may make use of US banks and vice versa). As would be obvious, borrowing from foreign lenders comes with currency rate fluctuations. Repaying a local (as in country) lender is straightforward – if the company has the money and willing to repay, then the debt is paid. But, in the case of foreign currency debt, companies would have to consider currency rates and decide if it is lucrative to repay debt at that existing currency rate or watch market forecasts and calculate if they would be in better health by holding off until when they think the exchange rate will be stronger (they may also invest overseas at such a time). Foreign currency debt throws another variable into the mix but thankfully, agencies evaluate an organization's ability to repay debts in local and foreign currencies. If the organization has foreign currency debt but does not have sufficient foreign currency reserves, then their rating may be lower. Corporate Credit Rating Corporate credit ratings range from the highest quality (best) to junk level (worst). Agencies use different designations but in general, long-term ratings are denoted by the letters AAA (triple A), which is the best credit rating (meaning low credit risk) and C or D (based on the agency) is the worst (default level as in failing to meet obligations). There are subsets to the basic category, which might involve a "+" or "-" sign to indicate subclasses (again, varies based on the agency). For example, the Fitch Ratings use AAA, AA, AA, BBB for investment grade and BB, B, CCC, CC, C, D and NR (not rated) for non-investment grade bonds. A good credit rating helps a corporation attract new partners or retail investors, apply for an increase to their line of credit, or sell their business. Sovereign Credit Rating A sovereign credit rating provides information about a country’s ability to provide a stable and secure investment market. This rating is contingent on a country’s economic status, market transparency, foreign investments, currency (local and foreign) reserves, and political stability to name a few. Potential investors can analyze the country-level risk associated with the company they are looking at and arrive at their decision. A sovereign rating is critical, since it will boost the country's prospects in terms of pulling in foreign investments and assisting in the growth of the economy. In the next part, we'll look at some metrics worth knowing about when purchasing corporate bonds. About the Author: Clark is a twenty-something Saskatchewan resident employed in the manufacturing sector. He repaid around $20,000 in student loans and has been working to build his investment portfolio as a DIY investor (not trader) while nurturing plans to retire early. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. Popular Posts: Canadian Discount Brokerage Comparison Top 6 ways to Save on Auto Insurance High Interest Rate Savings Accounts MBNA SPG Credit Card Review Questrade Review Are Hybrid Vehicles Worth it? Tax Free Savings Account (TFSA) Copyright 2010 MillionDollarJourney – All Rights Reserved