Topic Nine:

Corporate Debt
Evelyn Lai

FINS2622
Asian Pacific
Capital Markets
 This lecture

›In this lecture, we will cover the following:

- Yield curves
- Risk structure of interest rates
- Credit risk and default risk
- Credit analysis

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 Corporate debt instruments

› Corporate debt instruments are

financial obligations of a corporation that
have priority over its common stock and
preferred stock in the case of bankruptcy.

› A bond is a long-term debt instrument

issued by governments and
corporations that has promised future
payments and a maturity date.

› Owners of a bond receive periodic

interest payments over the life of the
bond and also get back the principal
amount at maturity.
 Yields
› Yield is the total return on an investment, comprising
interest received and any capital gain (or loss).

› Yield curve is a graph, at a point in time, of yields on an

identical security with different terms to maturity. It
illustrates the term structure of interest rates.
 The yield curve
› There are three main types of yield curves that are
usually observed in the market:
1. Normal or positive yield curve
- Longer term interest rates are higher than shorter term rates
- Acceleration in economy

2. Inverse or negative yield curve

- Short-term interest rates are higher than longer term rates
- Downturn in economy

3. Humped yield curve

- Shape of yield curve changes over time from normal to inverse
 Term structure of interest rates
› The shape of the yield curve changing over time suggests
that monetary policy interest rate changes are not the only
factor affecting interest rates.

› Three theories have been advanced to explain the shape

of the yield curve observed:
1. Expectations theory
2. Market segmentation theory
3. Liquidity premium theory
 1. Expectations theory
› The current short-term interest rate and expectations
about future short-term interest rates are used to explain
the shape and changes in shape of the yield curve.

› Longer term rates will be equal to the average of the

short-term rates expected over the period.
 1. Expectations theory
› The expectations theory of the shape of the yield curve
is based on a number of assumptions:
- Large number of investors with reasonably homogenous expectations
- No transactions costs and no impediments to interest rates moving to their
competitive equilibrium levels
- Investors aim to maximise returns and view all bonds as perfect substitutes
regardless of term to maturity
 1. Expectations theory
› The explanation behind the shape of the yield curve
under expectations theory:
1. Normal or positive yield curve
- Expectations that future short-term rates will be
higher than current short-term rates

2. Inverse or negative yield curve

- Expectations that future short-term rates to be
lower than current short-term rates

3. Humped yield curve

- Expectations that short-term rates to rise in the future but to fall in subsequent periods
 2. Segmented markets theory
› The segmented markets theory assumes that securities
in different maturity ranges are viewed by market
participants as imperfect substitutes.

› Two assumptions of the expectations theory are rejected:

- All bonds are perfect substitutes for one another
- Investors are indifferent between instruments with short-term maturity or
longer-term maturity
 2. Segmented markets theory
› Preferences of participants are motivated by reducing the
risk of their portfolios. They aim to minimise exposure to
fluctuations in prices and yields.

› Thus, the shape of the yield curve is determined by the

relative demand and supply of securities along the
maturity spectrum.

Central bank sales of short-term securities Central bank sales of long-term securities
 3. Liquidity premium theory
› The segmented markets theory assumes investors
prefer shorter term instruments, which have greater
liquidity and less maturity and interest rate risk. Therefore,
they require compensation for investing longer term.

› This compensation is termed as a liquidity premium,

which is the higher return received for the increased risk
of investing for a longer period of time.
 3. Liquidity premium theory
› The liquidity premium is included in the expectations
theory equation
 Risk structure
› Default risk is the risk that the borrower will fail to meet
its interest payment obligations.

› (Commonwealth) Government bonds are assumed to

have zero default risk. As they are risk-free, they offer a
risk-free rate of return.

› Some borrowers may have greater risk of default. The

extent of risk will vary from borrower to borrower.

› Investors will require compensation for bearing the extra

default risk.
 Credit risk
› Corporate debt instruments can be classified as follows:
(1) corporate bonds
(2) medium-term notes
(3) commercial paper
(4) bank loans
(5) convertible corporate bonds
(6) asset-backed securities

› Beyond the type of debt obligation and the corporate debt

sectors, corporate instruments are classified based on
their credit risk as gauged by the credit rating assigned
by the major credit rating companies.
 Credit risk
› Professional money managers use various techniques to
analyse information on companies and bond issues in
order to estimate the ability of the issuer to live up to its
future contractual obligations.

› Some large institutional investors and many banks have

their own credit analysis departments. Other institutional
investors do not do their own analysis but instead rely
primarily on recognised rating companies that perform
credit analysis and issue their conclusions in the form of
ratings.
 Bond ratings and default risk
› Bond ratings indicate the default risk (the probability that
the firm will not make the bond’s promised payments).
- Rating agencies use borrower’s financial statements, financing mix,
profitability, variability of past profits… and make judgments about the
quality of the borrower in order to determine ratings.
Bond ratings and default risk
 Default risk
› Default risk is one of the dimensions of credit risk.
- For a corporate debt obligation, default risk is the risk that the corporation
issuing the debt instrument will fail to satisfy the terms of the obligation with
respect to the timely payment of interest and repayment of the amount
borrowed.
Risk premium effect
 Credit analysis
› In the analysis of the default risk of a corporate bond
issuer and their specific bond issues, there are three
areas that are typically analysed:

1. The protections afforded to bondholders that are provided by covenants limiting

management’s discretion
2. The collateral available for the bondholder should the issuer fail to make the
required payments
3. The ability of an issuer to make the contractual payments to bondholders
The End