Corporate Bonds and Default Risks
Investors purchase corporate bonds as tools to 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. These default risks track prevailing economic conditions and the business prospects of the underlying company. Bondholders will evaluate numerous economic factors, before putting together their respective portfolios.
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. Bond principal, however, may not be repaid in full when the distressed company has limited resources and weak earnings power.
Interest rates are associated with the “cost of money.” Interest rates generally rise amid inflationary environments, when investors are desperate to preserve purchasing power. With time, however, higher interest rates may expose creditors to more defaults, as corporations struggle to service more expensive debt. To manage default risks, investors may prefer to purchase secured bonds, which are backed by collateral that may be sold off to recoup cash. Unsecured bondholders, however, must rely strictly upon good faith, for management to meet its debt obligations.
Credit Ratings Agencies
A credit rating agency, such as Standard and Poor’s, rates corporations according to their respective abilities to make debt payments. Smart investors will often appraise these ratings alongside their own fundamental analyses before putting money to work within 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. A ratings downgrade, of course, would be in line with elevated default risks.
Investors may purchase different types of bonds with varying maturity dates to manage default risks. Savers typically demand higher interest rates from longer-dated bonds, which are much riskier investments than overnight loans. Conservative savers will likely covet corporate bonds from prime rated companies, such as ExxonMobil and Microsoft. Alternatively, growth-oriented investors may prefer to carry high-yield, or junk bonds within their respective portfolios. Investors with long-term time horizons are more so able to recover from potential losses.
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 call debt, or demand that borrowers immediately repay all outstanding debt balances. Default risks then increase dramatically, and bond market values crash. At these times, the smart money will purchase assets on the cheap.