PArT 2: VALUATION, rISk AND reTUrNThe coupon rate as noted is 10%, paid quarterly until 27 October 2014: this amounted to 2.5% ∴
$100 = $2.50 per quarter because the bond face or par value was $100. The date for the next coupon
payment was 17 November 2012, and the bond could have been bought back (‘converted’) by the bank
on 27 October 2014. (As some background on this issue, the bank declared in its original prospectus for
the note issue that it also had the right to switch the notes to a floating coupon rate from the fixed 10%
rate at that date in 2014.)
Finally, in the rightmost column, the YTM for these bonds at the last traded date was 6.3%. This is
less than the 10% coupon rate, which is consistent with the bond price being above $100.^13
It is interesting to note that the same organisation issued another set of bonds (coded HBSHB) in
June 2012. The fixed coupon rate on these was 7.25% for a maturity of five years. The risk rating – a
concept discussed later in this chapter – was about the same (BBB–) as that for the bonds listed in our
table here. Both sets of bonds were unsecured, and the organisation’s economic health had not changed
much during the period 2009–2012. So why was the coupon rate lower for the bonds issued in 2012
than for those issued in 2009? The variation in coupon rates suggests these bonds may have been issued
originally in different market conditions. Interest rates in Australia in 2009 were generally higher than
those in 2012 (as we can see from the graph of government bond yields in Figure 4.3), so that the issuer
of the Heritage bonds would have been able to set a lower coupon rate on the bonds of 2012, to match
concurrent yields.
Traders often refer to the yield spread on a particular bond. The yield spread equals the difference
in yield to maturity between a corporate bond and a government bond at roughly the same maturity. By
convention, yield spreads are quoted in terms of basis points, where one basis point equals 1/100 of 1%
(100 basis points = 1.000%). Because corporate bonds are riskier than government bonds, they offer
higher yields, so the yield spread is always a positive number. For example, the yield on a government
bond maturing in 2019 was 2.713% on Friday 5 October 2012. So the yield spread on the Heritage Note
was 3.587% (6.300% – 2.713%), or 358.7 basis points, at that date.^14
As you might expect, bond yield spreads reflect a direct relationship with default risk. The greater the
risk that the borrower may default on its debts, the higher the spread that bonds issued by the borrower
must offer investors to compensate them for the risk that they take. For investors, estimating the default
risk of a particular bond issue is a crucial element in determining what the required return on the bond
should be. Fortunately, bond investors have several resources at their disposal to help them make this
evaluation.4-4b BOND rATINGS
For information on the likelihood that a particular bond issue may default, investors turn to bond rating
agencies such as Moody’s, Standard & Poor’s (S&P) and Fitch. While there are other ratings agencies in
different countries, these ‘big three’ international agencies dominate the global market, covering up to
90% of it, by some estimates. These organisations provide assessments of the risk of most publicly traded
bond issues, and they assign a letter bond rating to each issue to indicate its degree of risk. Table 4.3
lists the major bond-rating categories provided by each of the agencies and the interpretation associated
with each rating class. Bonds rated BBB– or higher by S&P and Fitch, and Baa3 or higher by Moody’s,
fall into the investment-grade category. Bonds rated lower than that are called high-yield, speculative13 Full details of the Heritage Note issue are in the prospectus given at http://www.asx.com.au/asxpdf/20090925/pdf/31kxsy498fnt22.pdf.
14 Source for government bond yield: http://www.bloomberg.com/markets/rates-bonds/government-bonds/australia/. Accessed 3 February 2015.yield spread
The difference in yield to
maturity between a corporate
bond and a government bond
at roughly the same maturity
basis point
1/100 of 1%; 100 basis points
equal 1.000%bond ratings
Letter ratings assigned to
bonds by specialised agencies
that evaluate the capacity of
bond issuers to repay their
debts. Lower ratings signify
higher default riskYield spreads vary through
time. Suppose you plot the
yield spread on AAA bonds over
several years. How would you
expect this spread to behave
during recessions compared with
economic booms?
thinking cap
question