Introduction to Corporate Finance

4: Valuing Bonds

or junk bonds. The term ‘junk bonds’ has a derogatory connotation, but simply means that these bonds

are riskier than investment-grade bonds. For example, for bonds in the investment grade category, the

probability of default is extremely low, perhaps as low as 1%. Over the period 2012–2014, the default

rate of speculative grade global debt (BB+ and lower by Standard & Poor’s rating) declined from 1.14%

to 0.69%.^15

Table 4.4 shows the relationship between bond ratings and yield spreads for corporate bonds at

different maturities at a given point in time. The data given on yield spreads are for the US, but the three

ratings agencies use the terminology on a global basis. The yield spreads are quoted in basis points. The

first entry in the top-left corner of the table shows a corporate bond with the highest possible Aaa/AAA

rating and a maturity of one year. It offered investors a YTM that was just 10 basis points higher than a

one-year US Treasury bill (short-term note) at the given point in time. Moving across the row, we see that

yield spreads increase with time to maturity. As expected, yield spreads increase as you move down the

rows. The bottom row shows that the lowest-rated bonds, those that are at or near the point of default,

offer yields that are 9–10% higher than comparable US Treasury securities of comparable maturity. To

illustrate an extreme case, suppose that the YTM on a 10-year US Treasury bond equals 3%. The last

entry in Table 4.4 shows that a 10-year US corporate bond rated Caa/CCC must offer a yield that is

9.55% higher than the US Treasury bond, or 12.55%. If that seems like an attractive return, remember

the risk dimension. An investor who buys a large number of bonds rated Caa/CCC will almost certainly

not earn an average yield of 12.55%, because some of these bonds will default. When default occurs,

bondholders usually do not receive all the payments they were originally promised, so the yield they

realise on their bonds falls short of the promised YTM.^16

15 Data from National Association of Corporate Treasurers, http://www.nact.org/resources/2014_SP_Global_Corporate_Default_Study.pdf. Accessed
12 October 2015.
16 According to the Salomon Center for the Study of Financial Institutions, the default rate among US junk bonds reached a record 12.8% in

2002. In a very rough sense, this means that one of eight junk bond issues in the market defaulted that year. The Center estimates that
      investors who held defaulted bonds recovered only 25% of par value. With the improving economy in 2003, the default rate fell to 4.6% and
      the recovery rate increased to 45%.

junk bonds

Bonds rated below investment

grade. Also known as high-

yield bonds or speculative

bonds

TABLe 4.3 BOND RATINGS

Bond rating agencies such as Moody’s, Standard & Poor’s and Fitch assign bond ratings based on their assessment of the
borrower’s ability to repay. Bonds in the top four ratings categories are investment-grade bonds, while those rated lower
are junk bonds.

Rating class Moody’s S&P and Fitch

Highest quality Aaa AAA Investment-grade

bonds

High quality Aa1, Aa2, Aa3 AA+, AA, AA–

Upper medium A1, A2, A3 A+, A, A–

Medium Baa1, Baa2, Baa3 BBB+, BBB, BBB–

Non-investment grade Ba1, BB+

Speculative Ba2, Ba3 BB, BB– Junk bonds

Highly speculative B1, B2, B3 B+, B, B–

Very risky, default Caa1 or lower CCC+ or lower

Why might companies try to

maintain a given target rating

on their outstanding debt?

thinking cap

question