Corporate Bonds

A bond is a security issued by a debtor to its creditors (investors) which promises a certain repayment structure.

To value a bond, discount future cash flows (coupons, notional) using the appropriate zero-coupon rates (equivalently, discount factors): $$P_0 = \sum_{j=1}^{J} \frac{CF_j}{(1 + y_j)^j}$$

The yield-to-maturity (YTM) is the average return, assuming reinvestment of coupons at this average return.

You should not use YTM for decision making because the YTM concept assumes a flat term structure.

Modified duration (MD) is a measure of the sensitivity of a bond's price to changes in its yield: $$MD = \frac{1}{1 + YTM} \sum_{j=1}^{J} \frac{T_j \cdot CF_j}{(1 + YTM)^j} / P_0$$

Modified duration relates to bond price sensitivity by approximating the percentage change in bond price for a small change in yield: If the yield goes up by a small amount, say $$\Delta y$$, then the price of the bond goes down by approximately $$MD \cdot \Delta y$$ percent.

Government bonds typically have low default risk, often assumed to be non-existent, while corporate bonds have wide heterogeneity in default risk and are typically analyzed in detail.

The main types of seniority in corporate bonds are secured bonds, guaranteed bonds, senior or unsecured bonds, and junior or subordinated bonds.

Bond covenants are contractual arrangements to mitigate the bondholder-shareholder conflict by including restrictions on investments, payouts, subsequent financing, and events.

A callable bond allows the issuer to buy back (or redeem) bonds in the future at a pre-specified price, requiring a higher coupon initially.

A putable bond gives the investor the option to sell back (or redeem) the bond to the issuer at a pre-specified price, resulting in a lower coupon.

A convertible bond allows the owner to convert the bond into shares of company stock, resulting in a lower coupon.

Most investors prefer to hold bonds denominated in their own currency to avoid FX risk; if they hold bonds in foreign currency, they often hedge the FX risk.

The size of the U.S. fixed income market in 2023 is approximately 57.1 trillion USD, with Treasury bonds making up 46% of the market.

The main holders of U.S. Treasury bonds are financial institutions, households, and other entities including governments and non-financial businesses.

The credit spread is the extra yield that corporate bonds trade at relative to treasuries, reflecting higher default risk.

Credit spreads vary across different types of corporate bonds, with high yield bonds having higher spreads than investment grade bonds.

The bond spread captures credit risk, a credit risk premium, a liquidity premium, tax effects, and investor preferences.

Credit ratings are independent opinions on creditworthiness, using a common terminology to help investors make informed decisions.

The main credit rating agencies are Standard & Poor’s, Moody’s, and Fitch.

Credit ratings affect the investment process by guiding investors in assessing the relative value of securities and the creditworthiness of issuers, and by influencing regulatory restrictions and index construction.

A transition matrix shows the probability that a bond with a certain rating will have a different rating in the future, with the last column relating to default.

Recovery rates vary across different types of corporate bonds, with secured bonds having the highest recovery rates and subordinated bonds having the lowest.

The Merton model of bond pricing applies option pricing theory to the pricing of corporate debt, viewing debt as the face value minus a put on the firm’s assets.

The Merton model applies option pricing theory by treating equity as a contingent claim on firm value with a payoff profile similar to a European call option.

A credit default swap (CDS) is a financial contract that hedges credit risk by allowing a protection buyer to purchase insurance against a contingent credit event.

The CDS-bond basis is the difference between the CDS spread and the risky bond yield spread, proxying for non-default components of the bond spread.

The liquidity risk premium in corporate bonds is the fraction of the bond spread not explained by credit risk, ranging from about 20% for BB bonds to about 50% for AAA and AA bonds.

Fallen angels are BB-rated bonds that have been downgraded from investment grade, often leading to fire-sale prices and strong performance.

Cross-sectional bond return predictors relate to equity factors by showing that profitability, asset growth, and lagged equity returns predict bond returns, with higher significance for non-investment grade bonds.