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Risk
Premiums Signal Financial Problems
Bond investors routinely
scrutinize a company’s financial fitness more rigorously than do stock
investors. If bond traders spot a problem, they’ll demand a higher
bond yield, or “risk premium,” to compensate for the added risk
before they’ll buy a company’s bonds.
Thus, checking a
company’s bond risk premiums could give stock investors a “heads
up” on potential financial problems.
For instance, Kmart
finally threw in the towel and filed bankruptcy last month, but its
bonds traded at close to a 3 percent risk premium all last year.
Web-hosting company Exodus’ bonds traded at a 28 percent risk premium
more than six weeks before its September 26, 2001 bankruptcy filing.
Enron’s risk premiums, mostly in the 5% to 7% range, signaled problems
a month before the energy trader filed for bankruptcy on December 2.
Until recently, figuring
out the risk premium priced into a bond was a mind-boggling puzzle. But
BondVillage.com, a relatively new Website, makes it a piece of cake.
Here’s what you need to
know to interpret risk premiums.
Bond Ratings
Agencies such as such
as Standard & Poors rate most corporate bonds. The ratings reflect
the agencies’ view of the risk that the company will default on its
bond obligations.
The agencies use
combinations of letters and numbers to express their bond ratings. For
instance, S&P’s ratings of investment quality bonds listed in
order of descending quality are: ‘AAA,” ‘AA’, ‘A,’ and
‘BBB.’ Thus, ‘BBB’ rated bonds, although investment quality, are
not considered as secure as ‘AAA’ rated bonds. S&P’s ‘BB’
and ‘B’ ratings signify non-investment quality or “junk” bonds,
and ‘C’ ratings identify bonds in immediate danger of default.
S&P often adds a “+” or a “-“ to the rating to indicate that
it falls at the top or bottom of its rating group.
In a column
nearly a year-ago, I suggested using bond ratings to identify
financially troubled companies. That strategy alone would have helped
you avoid many firms that crashed and burned last year, but it doesn't
work when the rating agencies are slow to downgrade a risky firm. Enron,
for instance, wasn’t downgraded to “junk” status until four days
before it filed bankruptcy.
Bond Prices &
Yields
Corporate bonds trade
at prices determined by supply and demand, similar to stocks. However,
unlike stocks, there is no national quotation system for bonds, so you
could pay different prices for the same bonds, purchased at the same
time, from different dealers.
Although sold
in larger denominations, bond prices are quoted as if they were traded
in $100 increments. For instance, a $95 quote means that the bond is
trading at $95 per $100 of face value. If you did pay $95, you would
earn more than the bond’s stated, or coupon rate. For example, a bond
issued at six percent pays $6 annual interest, but your yield is 6.3
percent because you’re receiving $6 interest on a $95 investment.
Bonds can be
callable or non-callable. If callable, the corporation can redeem the
bonds before the scheduled maturity date. Most bonds are non-callable,
and for simplicity, we’ll stick with that category.
Yield to Maturity
“Yield to maturity,” your total return if you hold a bond to
maturity, is the bottom line for bond investors, and the basis for
determining risk premium.
Spotting Risk Premium
The issuing company’s perceived
default risk is by no means the only factor that determines a bond’s
yield to maturity. Treasury bond rates, the bond rating, the economic
outlook, and a host of other factors figure into the equation.
BondVillage.com
(www.bondvillage.com) makes the
job easy because it tabulates average bond yields to maturity for each
of S&P’s investment quality bond ratings, and then for eight
different “years to maturity” ranging from six months to 30 years
for each S&P rating.
Once you know
what the average bond with the same credit rating and years to maturity
is yielding, the risk premium is simply the difference between the
average and your bond’s yield. You can find both on BondVillage.
Get Bond Yield
Start by selecting Bond Quotes (left menu) and then click on
“Corporate.” I’ll use Wal-Mart to demonstrate the process.
Type the first few letters of
the company name (e.g. “wal”) into the “Issue” box. Use the
first few letters because, for instance, Bond Village lists Wal-Mart in
its database as “Wal Mart” and it won’t find it if you search for
“Wal-Mart.” In response, BondVillage lists Wal-Mart’s current bond
quotes, that is, bonds offered for sale.
Once you’ve found it,
BondVillage lists Wal-Mart's current bond quotes, that is, bonds offered
for sale.
Each quote is listed on a
separate line, even if several are for the same bond. In this case,
BondVillage listed 19 quotes involving eight different bonds for
Wal-Mart. Since quotes for the same bond often vary in price, you’ll
see different yields to maturity (labeled “Yield”) listed for the
same bond. I’ve found that it’s best to find a bond with three or
more quotes.
You only need
to look at four items: the S&P bond rating, the maturity date, the
yield, and whether is bond is callable or not. Stick with bonds labeled
“NC” for non-callable. I found three quotes for a Wal-Mart ‘AA’
rated bond maturing in August 2006, about 4.5 years away. The three
quote’s yield to maturity varied, but the values hovered around 4.4
percent.
Get Average Yield
Next, select bvPerspectives (left
menu) and click on Corporate. The information you need is in a table
labeled “Non-Callable vs. Years to Maturity.” Print it out since
you’ll be referring to it frequently.
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