Fixed Income Securities III: Credit Analysis, Bond Spreads and Relative Value Measurement

Abstract

The risks associated with holding a fixed-interest debt instrument are closely connected with the ability of the issuer to maintain the regular coupon payments as well as redeem the debt on maturity. Essentially the credit risk is the main risk of holding a bond. Only the highest-quality government debt, and a small number of supra-national issues, may be considered to be entirely free of credit risk. Therefore, at any time, the yield on a bond reflects investors’ views on the ability of the issuer to meet its liabilities as set out in the bond’s terms and conditions. A delay in paying a cash liability as it becomes due is known as technical default and is a cause for extreme concern for investors; failure to pay will result in the matter being placed in the hands of the court as investors seek to recover their funds. To judge the ability of an issue to meet its obligations for a particular debt issue, for the entire life of the issue, requires judgemental analysis of the issuer’s financial strength and business prospects. There are a number of factors that must be considered; and larger banks, fund managers and corporates carry out their own credit analysis of individual borrowers’ bond issues. The market also makes a considerable use of formal credit ratings that are assigned to individual bond issues by a formal credit rating agency. In the international markets the most influential ratings agencies are Standard & Poor’s Corporation (S&P), Moody’s Investors Service, Inc (Moody’s) and Fitch Investors Service, Inc (Fitch).