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DEFAULT RISK

Our focus so far has been on U.S. Treasury bonds. But the federal government is not the only issuer of bonds. State and local governments borrow by selling bonds.6 So do corporations. Many foreign governments and corporations also borrow in the United

States. At the same time U.S. corporations may borrow dollars or other currencies by issuing their bonds in other countries. For example, they may issue dollar bonds in London which are then sold to investors throughout the world.

There is an important distinction between bonds issued by corporations and those issued by the U.S. Treasury. National governments don t go bankrupt they just print more money.7 So investors do not worry that the U.S. Treasury will default on its bonds.

However, there is some chance that corporations may get into financial difficulties and may default on their bonds. Thus the payments promised to corporate bondholders represent a best-case scenario: the firm will never pay more than the promised cash flows, but in hard times it may pay less.

The risk that a bond issuer may default on its obligations is called default risk (or credit risk). It should be no surprise to find that to compensate for this default risk companies need to promise a higher rate of interest than the U.S. Treasury when borrowing money. The difference between the promised yield on a corporate bond and the yield on a U.S. Treasury bond with the same coupon and maturity is called the default premium. The greater the chance that the company will get into trouble, the higher the default premium demanded by investors.

The safety of most corporate bonds can be judged from bond ratings provided by Moody s, Standard & Poor s, or other bond-rating firms. Table 3.1 lists the possible bond ratings in declining order of quality. For example, the bonds that receive the highest Moody s rating are known as Aaa (or triple A ) bonds. Then come Aa ( double A ), A, Baa bonds, and so on. Bonds rated Baa and above are called investment grade, while those with a rating of Ba or below are referred to as speculative grade, high-yield, or junk bonds.

It is rare for highly rated bonds to default. For example, since 1971 fewer than one in a thousand triple-A bonds have defaulted within 10 years of issue. On the other hand, almost half of the bonds that were rated CCC by Standard & Poor s at issue have defaulted within 10 years. Of course, bonds rarely fall suddenly from grace. As time passes and the company becomes progressively more shaky, the agencies revise the bond s rating downward to reflect the increasing probability of default.

As you would expect, the yield on corporate bonds varies with the bond rating. Figure 3.9 presents the yields on default-free long-term U.S. Treasury bonds, Aaa-rated corporate bonds, and Baa-rated bonds since 1954. It also shows junk bond yields starting in November 1984. You can see that yields on the four groups of bonds track each other closely. However, promised yields go up as safety falls off.

DEFAULT PREMIUM

The additional yield on a bond investors require for bearing credit risk.

INVESTMENT GRADE

Bonds rated Baa or above by Moody s or BBB or above by Standard & Poor s.

JUNK BOND Bond with a rating below Baa or BBB.

DEFAULT (OR CREDIT) RISK The risk that a bond issuer may default on its bonds.

6 These municipal bonds enjoy a special tax advantage; investors are exempt from federal income tax on the coupon payments on state and local government bonds. As a result, investors are prepared to accept lower yields on this debt.

7 But they can t print money of other countries. Therefore, when a foreign government borrows dollars, investors worry that in some future crisis the government may not be able to come up with enough dollars to repay the debt. This worry shows up in the yield that investors demand on such debt. For example, during the Asian financial crisis in 1998, yields on the dollar bonds issued by the Indonesian government rose to 18 percentage points above the yields on comparable U.S. Treasury issues.

Promised versus Expected Yield to Maturity

Bad Bet Inc. issued bonds several years ago with a coupon rate (paid annually) of 10 percent and face value of $1,000. The bonds are due to mature in 6 years. However, the firm is currently in bankruptcy proceedings, the firm has ceased to pay interest, and the bonds sell for only $200. Based on promised cash flow, the yield to maturity on the

bond is 63.9 percent. (On your calculator, set PV = 200, FV = 1,000, PMT = 100, n = 6, and compute i.) But this calculation is based on the very unlikely possibility that the firm will resume paying interest and come out of bankruptcy. Suppose that the most likely outcome is that after 3 years of litigation, during which no interest will be paid, debtholders will receive 27 cents on the dollar that is, they will receive $270 for each bond with $1,000 face value. In this case the expected return on the bond is 10.5 percent. (On your calculator, set PV = 200, FV = 270, PMT = 0, n = 3, and compute i.) When default is a real possibility, the promised yield can depart considerably from the expected return. In this example, the default premium is greater than 50 percent.