DEFAULT RISK AND BOND PRICING
Although bonds generally promise a fixed flow of income, that income stream is not riskless unless the investor can be sure the issuer will not default on the obligation. While U.S. government bonds may be treated as free of default risk, this is not true of corporate bonds. If the company goes bankrupt, the bondholders will not receive all the payments they have been promised. Therefore, the actual payments on these bonds are uncertain, for they depend to some degree on the ultimate financial status of the firm. Bond default risk is measured by Moody’s Investor Services, Standard & Poor’s Corporation, and Fitch Investors Service, all of which provide financial information on firms as well as the credit risk of large corporate and municipal bond issues. International sovereign bonds, which also entail default risk, especially in emerging markets, also are commonly rated for default risk. Each rating firm assigns letter grades to reflect its assessment of bond safety. The top rating is AAA or Aaa. Moody’s modifies each rating class with a 1, 2, or 3 suffix (e.g., Aaa1, Aaa2, Aaa3) to provide a finer gradation of ratings. The other agencies use a 1 or 2 modification.
Determinants of Bond Safety
Bond rating agencies base their quality ratings largely on an analysis of the level and trend of some of the issuer’s financial ratios. The key ratios used to evaluate safety are:
Although bonds generally promise a fixed flow of income, that income stream is not riskless unless the investor can be sure the issuer will not default on the obligation. While U.S. government bonds may be treated as free of default risk, this is not true of corporate bonds. If the company goes bankrupt, the bondholders will not receive all the payments they have been promised. Therefore, the actual payments on these bonds are uncertain, for they depend to some degree on the ultimate financial status of the firm. Bond default risk is measured by Moody’s Investor Services, Standard & Poor’s Corporation, and Fitch Investors Service, all of which provide financial information on firms as well as the credit risk of large corporate and municipal bond issues. International sovereign bonds, which also entail default risk, especially in emerging markets, also are commonly rated for default risk. Each rating firm assigns letter grades to reflect its assessment of bond safety. The top rating is AAA or Aaa. Moody’s modifies each rating class with a 1, 2, or 3 suffix (e.g., Aaa1, Aaa2, Aaa3) to provide a finer gradation of ratings. The other agencies use a 1 or 2 modification.
Determinants of Bond Safety
Bond rating agencies base their quality ratings largely on an analysis of the level and trend of some of the issuer’s financial ratios. The key ratios used to evaluate safety are:
- Coverage ratios. Ratios of company earnings to fixed costs. For example, the times-interestearned ratio is the ratio of earnings before interest payments and taxes to interest obligations. The f ixed-charge coverage ratio includes lease payments and sinking fund paymentswith interest obligations to arrive at the ratio of earnings to all fixed cash obligations. Low or falling coverage ratios signal possible cash flow difficulties.
- Leverage ratio. Debt-to-equity ratio. A too-high leverage ratio indicates excessive indebtedness, signaling the possibility the firm will be unable to earn enough to satisfy the obligations on its bonds
- Liquidity ratios. The two common liquidity ratios are the current ratio (current assets/current liabilities) and the quick ratio (current assets excluding inventories/current liabilities). These ratios measure the firm’s ability to pay bills coming due with its most liquid assets.\
- Prof itability ratios. Measures of rates of return on assets or equity. Profitability ratios are indicators of a firm’s overall performance. The return on assets (earnings before interest and taxes divided by total assets) or return on equity (net income/equity) are the most popular of these measures. Firms with higher return on assets or equity should be better able to raise money in security markets because they offer prospects for better returns on the firm’s investments.
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