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Credit risk in bonds

By David Luhman on Sat, 05/09/2009 - 23:34

Credit risk in bonds

I've tried to emphasize interest rate risk when you invest in bonds because many people don't understand this risk even though it's probably the biggest risk facing today's bond investor.

But almost everyone understands credit risk. Credit risk is the risk that the issuing company or government can't meet the promised interest or principal payments.

US Treasuries face least credit risk

In this case, US Treasury bonds and mortgage securities called Ginnie Maes offer the highest credit ratings. These securities are backed by the "full faith and credit" of the US government.

Government agency securities

After US Treasuries and Ginnie Maes come debt issued by quasi-governmental agencies like the Federal Home Loan Mortgage Corporation also known as Freddie Mac.

Although debt issued by these corporations does not carry the explicit backing of the US government, most bond traders believe the government will back up the companies if their bankruptcy is threatened.

Blue chip corporations

Next comes the debt of large, blue chip corporations like General Electric. This debt is normally called investment grade debt. Debt issued by large corporations is normally rated by independent companies like Moody's, and Standard & Poors. These companies do extensive research into the issuing company's ability to repay their bonds.

Hierarchy of claims

Before we jump further down into junk bonds, we should spend a little time talking about the hierarchy of claims on a company's assets and see what happens if a company files or is forced into bankruptcy.

According to the US Constitution, bankruptcy proceedings are handled by federal law. US bankruptcy laws were rewritten in 1978 to change the traditional pecking order of those who can make claims against a bankrupt company.

Lawyers and the IRS are highest

Highest on the pecking order is the bankruptcy lawyers. Lawyers write the laws, so it shouldn't be too surprising that they want to get paid for their efforts as they try to dole out the company's assets.

Next comes the IRS, then the firm's employees and their pension funds. After them come the company's secured creditors. These creditors have loaned the company money, but the loan is secured by a mortgage on a piece of real property like a building or heavy equipment.

Most blue chip debt is unsecured

Although secured debt is common for smaller companies, the majority of blue chip corporate debt is unsecured debentures. Here the lender only has the promise that the firm will honor its debt. This is similar to unsecured credit card debt that most consumers carry.

However, there are several levels of unsecured debt. So-called senior debt holders are paid off before junior or subordinated debt holders. Unsecured creditors also include the suppliers who provided the company with merchandise.

After the junior debt holders come the preferred stockholders. Finally, if there's any money left, the common stockholders receive compensation for their ownership in the company.

Chapter 11 and 7 bankruptcy

There are two forms of corporate bankruptcy, named for sections in the federal law which govern their policies.

One is Chapter 11, and this type appears in the news most often. In this case, the company continues operation, but it receives a temporary reprieve from its creditors while it works out a debt repayment plan.

The second is Chapter 7. In this more extreme case, the company is liquidated and assets are sold off to satisfy creditors.

A company can be forced into bankruptcy by its creditors if the company fails to meet its obligations. The company also voluntarily can choose to file for bankruptcy. Once in bankruptcy, a federal court plays a major role in the handling of claims.

Typical bankruptcy reorganization

Although it's difficult to generalize about bankruptcy proceedings, if a company files for bankruptcy, and then later re-emerges as an operating company, the old creditors and shareholders have their claims shifted down one level in the claims hierarchy.

For example, the old senior debt holders become junior creditors, the old junior debt holders become stockholders and the old stockholders lose everything or perhaps get some equity warrants.

Ratio analysis for credit worthiness

To avoid the unpleasantness of bankruptcy, bond investors and independent rating agencies analyze a company's financial condition. Typically, investors look at various ratios to see if the firm is a good risk. One of the most common ratios is the firm's current ratio.

Current ratio

The current ratio is the ratio of short-term assets to short-term debt, and it measures the ability of the firm to avoid bankruptcy in the short-run. A firm should have a current ratio of above 2.0.

Times interest earned ratio

Another ratio is the so-called times-interest-earned ratio. This ratio takes the firm's annual earnings before interest and taxes and divides it by the annual required interest payments. A ratio of four or more is considered good.

Debt to equity ratio

A third ratio is the firm's debt to equity ratio. This is the ratio of the firm's total debt to the book value of the company's stock. Most American companies have a debt to equity ratio of somewhere around one.

However, all these ratios and a firm's ability to carry debt vary with the type of company. Some companies are able to carry debt more safely than other companies.

For example beverage firms and retailers are all able to carry more debt than firms in volatile industries like computer manufacturing. In fact, many stable companies like consumer product firms should have a good deal of debt. If they don't, one of the easiest ways to increase the company's stock price is to issue more debt, and take the proceeds and buy back the company's stock.

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