Default Risk in Corporate Bonds
Investors look toward corporate bonds as a means to grow wealth and preserve purchasing power above the rate of inflation. Although bonds are conservative investments, relative to the stock market, all financial assets carry risks. Bonds are associated with default risks, or missed interest and principal payments. Default risks track prevailing economic conditions and the business prospects of the underlying company. Identify the factors influencing bond market performance, before putting together your investment portfolio.
Other People Are Reading
-
Identification
-
Corporations finance themselves by taking out loans, or issuing bonds to creditors. Creditors earn interest payments, until corporate bond principal is repaid at maturity. Bondholders do not own the company, but carry asset claims that are superior to those of shareholders. In the event of bankruptcy, bondholders are paid first from liquidated assets. Bonds, however, may not be repaid in full when the distressed company has limited resources. Default risks increase as earnings power deteriorates. Businesses report slack profits because of recession, increased competition or failed product lines.
Features
-
Interest rates describe the costs of money and are a key economic indicator. In general, interest rates rise in response to inflation concerns. At that point, investors covet higher returns to maintain asset purchasing power over inflation. Overall, higher interest rates increase the chances for corporate defaults because bond payments then become more expensive. Further, default risks shift according to the structure of each individual bond offered by a particular corporation. For example, secured bonds feature less default risks than unsecured bonds. Corporate net income and specific assets back secured bonds. Unsecured bondholders, however, must rely strictly upon good faith in management to make good on its business debt.
-
Considerations
-
Credit rating agencies, such as Standard and Poor's and Moody's, rate individual bonds and corporations according to their abilities to make payments. Compare these ratings against your own research of corporate annual reports, prior to making financial commitments into the bond market. Bonds are categorized into investment grade, non-investment grade, or default. Non-investment grade bonds are often referred to as high-yield, or junk bonds.
Strategy
-
Structure your bond portfolio to balance risks against rewards. Investors demand higher interest rates from riskier bonds, as compensation for potential losses. Coordinate asset allocation to match your financial goals and station in life. For example, first-time homebuyers saving money for a down payment on property, and retirees looking to preserve retirement income will prefer to limit risk exposure. These savers covet corporate bonds from prime rated companies, such as ExxonMobil and Microsoft. Alternatively, younger savers investing for growth may prefer to add more junk bonds to their respective asset allocation. Investors with long-term time horizons are more so able to recover from potential losses.
Risks
-
Systematic risks and credit crises adversely affect all bonds. Systematic risks identify the collapse of the entire financial system. In credit crisis, banks refuse to extend loans, and may even demand that borrowers repay all outstanding debt, immediately. Default risks then increase dramatically, and bond market values crash.
-
References
Resources
- Photo Credit cash image by Tom Oliveira from Fotolia.com
