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2.3.3 Corporate bonds and their pricing

Corporate bonds are loans to a company that work in essentially the same way as government bonds. The main difference is default risk. While investors may be confident that a government will repay its loans, a company might not. To compensate for default risk, the return on corporate bonds is normally higher than the return on government bonds with a similar maturity – this premium is called the ‘corporate bond spread’.

Figure 7 shows by what percentage the return on corporate bonds rated Baa by the ratings agency Moody’s exceeded the return on 10-year US government bonds between 1986 and 2023. Note that this difference (or ‘spread’) is often stated in basis points. A basis point is one-hundredth of 1% (0.01%). The figure illustrates how corporate bond spreads can move sharply in response to changing economic conditions. For example the 2007/08 financial crisis resulted in a sharp upward move in corporate bond credit spreads – and not just for financial sector companies. This reflected the (correct) expectation that the financial crisis would trigger a downturn in economic activity globally, thereby adversely affecting the corporate sector generally and increasing the risks associated with investing in corporate bonds.

Described image
Figure 7 Moody’s seasoned Baa corporate bond yield relative to yield on 10-year Treasury constant maturity (FRED Economic Research, 2023).

After 2009 spreads started to narrow again as some semblance of calm returned to the financial markets. More recently (in 2020) spreads widened again, mainly as a result of the adverse economic impact of the COVID-19 global pandemic. After the pandemic spreads narrowed again.

Few investors, personal or professional, have the time or means to investigate the credit worthiness of a company. One way to deal with this information gap is to refer to a credit rating agency, an organisation whose business is assessing risk and disseminating this type of information. The list below shows the rating scale used by one of the main international agencies. Personal investors will normally be looking only to invest in ‘investment-grade’ bonds, as defined in the figure. At the top end of the scale, a company assigned a ‘AAA’ rating is thought very unlikely to default on its bond payments, but this is not a guarantee or seal of approval – there is still some risk. The extent to which investors can and should be able to rely on the information from credit reference agencies is discussed later.

General summary of the opinions reflected by Standard and Poor’s credit ratings

Investment grade

  • AAA – Extremely strong capacity to meet financial commitments. Highest rating.

  • AA – Very strong capacity to meet financial commitments.

  • A – Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.

  • BBB – Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.

  • BBB– – Considered lowest investment grade by market participants.

Speculative grade

  • BB+ – Considered highest speculative grade by market participants.

  • BB – Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.

  • B – More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments.

  • CCC – Currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments.

  • CC – Currently highly vulnerable.

  • C – A bankruptcy petition has been filed or similar action taken, but payments of financial commitments are continued.

  • D – Payment default on financial commitments.

Ratings from AA to CCC may be modified by the addition of a plus (+) or minus (–) sign to show relative standing within the major rating categories.

(Standard & Poor’s, 2009)