Investing
Corporate Bonds Pay For Two Different Risks
The yield on a company's debt compensates for both the general level of interest rates and the chance the issuer fails, and the two components move independently.
A corporate bond yields more than government debt of the same maturity. That extra is not a single premium; it is compensation for a distinct risk that behaves differently from the rest.
The yield decomposes into two parts
One part reflects the return available on comparable debt considered free of default risk, which is driven by the general level of interest rates and expectations about them.
The other, the credit spread, compensates for the possibility that the issuer does not pay in full, and for the uncertainty about how much would be recovered if it did not.
Because these have different causes, they can move in opposite directions, and a bond's price can be pushed one way by rates and the other by credit at the same time.
Interest rate risk depends on maturity
The longer the remaining term, the more a change in rates affects the present value of the payments, which is why long-dated bonds move more for the same rate change.
This sensitivity is a property of the payment schedule rather than of the issuer, and it applies identically to a government bond with the same profile.
So two bonds from the same company with different maturities carry the same credit exposure and very different sensitivity to rates.
Credit spreads widen when conditions deteriorate
Spreads reflect collective assessment of default probability and recovery, and they widen when that assessment worsens or when investors demand more compensation for the same risk.
Widening tends to be correlated across issuers, because the conditions prompting it are usually economy-wide rather than company-specific.
This correlation is why corporate debt can fall alongside equities during stress, at the point when investors expected it to behave defensively.
Seniority determines what a claim is worth in failure
Debt sits ahead of equity in the order of claims, but not all debt is equal. Secured, senior and subordinated instruments recover in a defined sequence.
Recovery expectations therefore differ substantially between instruments from the same issuer, and the yield differences between them reflect that ordering.
Insolvency processes, priority rules and creditor protections vary considerably by jurisdiction and change over time, so recovery is jurisdictional as well as contractual.
Ratings are opinions with a defined scope
Credit ratings assess the likelihood of payment according to a published methodology, and they say nothing about whether the yield offered is adequate for that risk.
They also move, and a downgrade can force selling by holders whose mandates specify minimum ratings, which affects prices independently of the underlying deterioration.
Understanding a corporate bond therefore means holding two questions apart: what the payment schedule is worth at current rates, and how likely the schedule is to be honoured.
Questions readers ask
Does this mean I should sell before a fall?
Only if you can identify falls in advance, which the evidence suggests almost nobody does consistently. The practical response is choosing an allocation whose falls you can sit through.
Why do average returns overstate what I got?
Because averaging percentages ignores that each return applies to a different balance. The compound return accounts for that and is always lower when returns vary.
