Subniveles ajustados y operadores normales

So far we have concentrated on government bonds or - more precisely – on government bonds with the best credit standing (e.g. no Russian bonds). We have been assuming that these bonds are an investment without any risk as these countries have best credit

standings. When saying “without any risk” we are referring to the credit risk which is the risk of a loss which would occur if the counterparty defaulted. However, also banks and

corporates issue bonds. So the investor has a wider choice of investment opportunities. However, the purchase of a bond also always includes a loan to the issuer. Before granting a loan you ideally should examine the credit risk. This examination is quite complex regarding time and money. Thus standardised credit ratings have been developed. These ratings

classify credit users and bond issuers regarding their credit-worthiness with consistent methods. The rating gives international investors true benchmarks as a basis for their

investment decisions. Thus transparency and efficiency of the capital markets are increased.

Rating grades

The credit ratings are done by international rating agencies. The most important agencies

are Standard and Poor’s, Moody’s and Fitch IBCA.

Individual ratings for short-term debts (e.g. Commercial Papers, Certificates of Deposits) and long-term debts (e.g. bonds) are defined.

 Short-term ratings refer to the debtor’s ability to pay back short-term liabilities. It is necessary that the issuer has enough credit range for paying back bonds at maturity, called “back-up line of credit”.

 For long-term ratings (bond ratings) the agencies have developed benchmarks for the different debtor groups, e.g. for sovereign governments, municipalities, banks and corporates.

The different rating grades are marked with symbols.

CP-Ratings

(short-term)

Bond-Ratings

(long-term)

S&P's Moody's S&P's Moody's

A-1 P-1 AAA Aaa

A-2 P-2 AA Aa A-3 P-3 A A B (P=Prime) BBB Baa BB Ba C B B D CCC Caa CC Ca C C D

The bond ratings can be explained as follows:

 Group I: first-class addresses; these bonds have no risk for the investor.

 Group II: companies with a good through average standing; normally these bonds

can be regarded as safe bond investments if the economical background holds steady.

 Group III: bonds with speculative character. The issuers are in economical resp.

financial troubles; interest and redemption payments are not always guaranteed.

 Group IV: cash-strapped bonds

Issuers through rating BBB resp. Baa are called investment grade, i.e. they are regarded as

a safe investment.

Bonds with a worse rating are called speculative grade/ non-investment grade or junk bonds. Group I Group II Group III Group IV Investment Grade non-investment Grade (Speculative Grade, Junk Bonds)

Credit rating and yield

The basic principle in the financial markets is that higher risk has to be awarded with a higher return. Thus investors ask for a higher interest rate when the issuer’s rating is bad. Therefore the yield of AAA (spoken “triple A”) rated government bonds is the lowest. They are the interest rate for investments with the lowest credit risk and thus act as so-called benchmark yields. All bonds rated worse have to pay a premium to this benchmark. This premium is

called credit spread.

Quotation of interest rates

The interest rate for bonds are not only quoted as a fixed rate (e.g. 5%) but also as a

premium to the yields of government bonds, Interest Rate Swaps resp. EURIBOR or LIBOR.

Premium to the benchmark yield

The total yield is the result of the interest rate without risk plus the credit spread which depends on the issuer’s credit standing. If now an investor compares bonds of different issuers (e.g. corporates) s/he is mainly interested in the premium to the investment without risk. Thus s/he can better evaluate if the credit spread as compensation for the credit risk is enough. If only the credit spreads are quoted, an investor can compare different issuers more easily.

The quotation of a 10-year USD bond of an A (spoken: “single A”) rated US corporate could also be: 10-year Treasury bond + 120 BP. If the 10-year Treasury bond quotes at e.g. 5.00%, the bond of the A-issuer would be traded at 6.20%. Attention has here to be paid to the interest convention of the benchmark, e.g. semi-annual payments for Treasury notes.

Premium to the Interest Rate Swap Rate

Instead of the government bond yields interest rate swap rates are often used as reference rate for the interest rate. Then the credit spread is the difference to the IRS rate. The reason for this is that in recent years the risk management systematics could be further developed. Here different risks can be controlled separately. Thus the accounting of profit and loss for the individual causer can be shown more transparently. In the case of bonds the risks

involved are interest rate risk and credit risk. For the evaluation of the profit and loss not only the total result of the investment has to be regarded but also which part can be attributed to

government bonds as benchmark for the interest rate without risk. Looking at it closer, this is not very precise as the government bond yields are - like all loans - also composed of the actual interest rate without risk plus credit spread for the debtor country. What is the interest rate without risk in this consideration? It is the rate which can be fixed without any loan (i.e. without any liquidity), thus the interest rate swap rate.

The consequence is that it is becoming more and more common to define credit spreads not as difference to the particular government bond but as difference to the IRS rate.

Currently 5-year bonds from A rated German car suppliers are traded at a premium of 80 BP to the IRS rate. What are the costs for an issuer of this group when s/he wants to issue a 5-year fixed-rate interest bond?

First, s/he has to look where the actual 5-year IRS rate is. If it is at 4.50% s/he has to pay 5.30%.

Assuming an investor thinks the price of 80 BP is adequate but prefers a variable rate. This investor could conduct following transactions: purchase of the bond at IRS + 80 and payer swap at 4.50%.

The result is a variable investment at EURIBOR + 80 BP. It is composed of the EURIBOR payments in the IRS plus the difference between the bond interest rate and the fixed rate in the IRS.

As with an IRS a fixed rate position can be transferred into a variable one, the quotation of IRS + 80 BP corresponds to a variable interest rate of EURIBOR + 80 BP.

The combination of a bond (asset) and an IRS is called asset swap. When quoting on an

asset swap basis EURIBOR + credit spread is meant.

Note: Asset swaps are usually traded in packages, i.e. the seller of the bond is the partner for the swap at the same time. The bond is delivered – independent from the actual price – at 100 and the fixed rate in the swap equals the coupon of the bond. The variable payment in the swap is then not EURIBOR flat but EURIBOR + credit spread.

Fixed rate 5.30% Fixed rate 4,50% (IRS)

Bond

Credit spreads for government bonds

When looking at the historic yields of government bonds one can see that they are below the IRS rates, i.e. the spread to the IRS is negative. This means that government bonds on an asset swap basis usually quote at EURIBOR (resp. LIBOR) minus credit spread. The reason is that EURIBOR (resp. IRS) are the rates for first-class banks. As the credit standing of countries is higher than the credit standing of banks, the interest rate has to be lower than the interest rate for banks (EURIBOR).