Macaulay Duration
Definition Macaulay duration was introduced in the previous learning objective. It provides an... Read More
Corporate issuers use long-term debt to secure stable funding for a range of requirements, from short-term operations to long-term capital investments. However, the features and availability of such funding vary based on the credit quality of the issuer. While IG corporate issuers showcase a strong capacity to meet future obligations, HY issuers are vulnerable in meeting debt interest and principal payments.
Both IG and HY issuers are confronted with a series of considerations when issuing long-term debt. They weigh the relative risk against its costs or yield-to-maturity of long-term debt of different maturities. Moreover, both categories of issuers need to address concerns associated with interest rates, credit spreads, and maturity choices. The overarching issues of price risk, reinvestment risk, and rollover risk further bind these issuers in their decision-making process.
For IG Bonds, analysts typically lean on financial ratios and credit ratings to gauge the potential shift in an IG issuer’s likelihood of default. On the other hand, given their high-risk profile, HY bonds demand a more intricate analysis. Emphasis is placed on evaluating potential losses in the event of default. Moreover, analysts closely examine covenants, restrictions, and security pledges tied to HY bonds.
Investment-Grade Bonds:
High-Yield Bonds:
Investment-Grade Bonds:
High-Yield Bonds:
A unique subset within the high-yield universe is the “fallen angels” issuers. These are formerly investment-grade issuers who experienced a decline in their credit rating. However, their bonds still retain features characteristic of investment-grade instruments. These features include being non-callable, having minimal restrictions, and possessing longer maturities. However, any subsequent deterioration in the issuer’s credit quality can precipitate losses for the original investors. This decline is further exacerbated by the fact that the market for high-yield bonds is significantly smaller compared to the market for investment-grade bonds, which can have a pronounced effect on bond prices.
Question #1
In terms of maturities, which bond issuer typically has the flexibility to choose maturities that can extend up to 30 years?
- High-Yield Bonds
- Fallen Angels
- Investment-Grade Bonds
Solution
The correct answer is C:
Investment-Grade Bonds issuers have the flexibility in choosing maturities, and these can extend up to 30 years.
A is incorrect: High-Yield Bonds often have a more restrictive landscape, usually limited to maturities of 10 years.
B is incorrect: While Fallen Angels might retain some features of investment-grade instruments after a credit rating downgrade, the question specifically refers to the typical maturity of a particular type of bond, not a subset of issuers.
Question #2
In the context of credit quality, which of the following bonds typically carries a significant portion of its yield-to-maturity (YTM) attributed to issuer-specific spreads over benchmark yields?
- Bonds with predictable cash flows
- Investment-Grade Bonds
- High-Yield Bonds
Solution
The correct answer is C:
High-Yield Bonds typically have a significant portion of their YTM credited to issuer-specific spreads over benchmark yields due to the increased likelihood of default.
A is incorrect: The predictability of cash flows does not directly determine the portion of YTM associated with issuer-specific spreads.
B is incorrect: Investment-Grade Bonds generally have a lower proportion of their YTM attributed to credit spreads, reflecting their lower default risk.