Credit Risk

Credit Risk

Credit risk is only one aspect of risk in bonds

Who are the most - and least - credit worthy issuers

What happens if an issuer goes bankrupt?

What's backing up corporate debt?

Credit risk is only one aspect of risk in bonds

Interest rate (inflation) risk is probably the biggest risk facing most bond investors

But credit risk is the one that most investors think of first

Other forms of risk in bonds

• Prepayment or call risk
• Reinvestment risk
• Currency risk

Who are the most - and least - credit worthy issuers?

Typical yields as of September, 1996 for long-term (approx. 10 year maturity)

Bond issuer	Current yield	S&P rating	Moody's rating
US Treasury	6.5%	AAA	Aaa
GNMA	7.1	AAA	Aaa
Bell South	6.6	AAA	Aaa
Pacific Bell	6.6	AA-	Aa
IBM	7.4	A	A
McDonnell Douglas	8.2	A-	Baa
AMR (Am Airlines)	8.3	BB+	Baa
RJR Nabisco	8.9	BBB-	Ba

GNMA bonds are very safe with respect to credit risk, but face prepayment (call) risk so the yield is relatively high

What happens if an issuer goes bankrupt?

Very complicated proceeding

Heirarchy of claims

Quite complicated, depends on covenants in bonds and other securities

General heirarchy (from highest to lowest)

• IRS and bankruptcy lawyers have highest claim
• Pension liabilities come next
• Secured creditors
• Junior creditors
• Unsecured creditors (suppliers, salaries payable)
• Preferred stock holders
• Stock holders

Chapter 7 bankruptcy

• Liquidation of corporation's assets
• Remaining assets, if any, are passed out to highest creditors until it's all gone
• Elimination of the corporation

Chapter 11 bankruptcy

• Corporation continues to operate
• Generally, creditors exchange their debt for shares of stock
• Existing stockholders get a few warrants, if anything

What's backing up corporate debt?

Most bonds issued by major corporations have no security

That is, there is no collateral backing up the debt

Usually only stronger, larger corporations with good cash flow and a long operating history can issue bonds like this

Most smaller businesses must supply collateral to obtain loans or must supply personal guarantee of owners