The yield curve

The interest rate that lenders require of any borrower will depend on the term of the borrowing. The yield curve depicts the various rates at which the same borrower is able to borrow for different periods of time. The most closely watched yield curve in any country is that of the national government, which is the closest approximation to a risk-free yield. Other yield curves, such as the one for corporate borrowers, are best understood in comparison with the risk-free yield. The yield curve is drawn against two axes, the vertical showing yield (expressed in percentage points) and the horizontal giving the term in years. Most of the time the yield curve is positively sloped, going from the lower left corner of the chart to the upper right. In this case, very short-term borrowings would have the lowest yield, with the yield increasing as the term lengthens. The reasons for this shape are readily understandable, as lenders and investors wish to be compensated for the greater risk that i…

Ratings of risk

Before issuing bonds in the public markets, an issuer will often seek a rating from one or more private ratings agencies. The selected agencies investigate the issuer’s ability to service the bonds, including such matters as financial strength, the intended use of the funds, the political and regulatory environment, and potential economic changes. After completing its investigation, an agency will issue a rating that represents its estimate of the default risk, the likelihood that the issuer will fail to service the bonds as required. This rating is normally paid for by the issuer, although in some cases an agency will issue a rating on its own initiative. Three well-known companies, Moody’s Investors  Service and Standard & Poor’s, both based in New York, and Fitch ibca, based in New York and London, dominate the ratings industry. The firms’ ratings of a particular issue are not always in agreement, as each uses a different methodology. It interprets the default ratings of the three international firms. There are also many ratings agencies that operate in a single country, and several that specialise in a particular industry, such as banking.

All the ratings agencies emphasise that they rate only the probability of default, not the probability that the issuer will experience financial distress or that the price of its bonds will fall. Nonetheless, ratings are extremely important in setting bond prices. Bonds with lower ratings almost always have a greater yield than bonds with higher ratings. If an agency lowers its rating on a bond that has already been issued, the bond’s price will fall. Government regulations or internal procedures restrict the amount many pension funds and insurance companies can invest in bonds that have a high probability of default, those rated as “below investment grade”. Ratings have increased in importance because of the growing number of bonds with “step-up” and acceleration provisions. Under a typical step-up, a bond might be issued with a 7% coupon, but if the issuer’s credit rating is lowered, the coupon immediately increases to 7.25%. If the issue has an acceleration provision, the bonds could become repayable immediately upon a downgrade. In either case, the lowering of an issuer’s credit rating can have serious adverse consequences, both for the issuer and for the investors who hold its securities.

Interpreting the price of a bond

The price of a bond is normally quoted as a percentage of the price at which the bond was issued, which is usually reported as 100. In most countries, prices are quoted to the second decimal place. Thus a bond trading at 94.75% of its issue price will be quoted at 94.75 in most countries, indicating that a bond purchased for $10,000 when issued is currently worth $9,475. A price exceeding 100 means that the bond is worth more now than at the time it was issued. The prices of non-government bonds are often reported in terms of the spread between a particular bond and a benchmark. In the United States, confusingly, high-grade corporate bonds are usually quoted in terms of a spread over US Treasury yields at similar maturity; if the current yield on ten-year Treasuries is 5.20%, a bond quoted at 220 would yield 7.40% at its current price. High-yield bonds, however, are quoted as a percentage of the face value. For floating-rate instruments, the spread is often expressed in terms of the London Inter-Bank Offer Rate (libor), a key rate in the London market. In some cases, both the bid and ask prices are quoted. The interest rates on government bonds may be affected by the expectation that a particular bond issue will be repurchased rather than by economic fundamentals alone. This has made government bonds an increasingly unstable benchmark in some countries, and investors have been looking for other measures by which to judge the pricing of nongovernment
bonds.

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