Corporate Bonds and Expected Returns
Practice locating and evaluating sources and then integrating those sources into a researched argument.
Description: To complete this assignment, write an argument using the strategies and structures described in your textbook and the handbook. The argument should have an identifiable thesis, lines of argument, logical support, ethical and emotional appeals (if applicable), and consideration of alternative views.
You should use 6 sources from the TTU library or library databases as specified by your instructor for this assignment. Your essay should be 1500 words in length, not including the list of works cited. Please use MLA format (see Ch. 16 of your handbook) for in-text citations and your list of works cited.
The expected returns on bonds cannot be explained on the basis of systematic risk. Systematic risk refers to the risk in the market overall. Yet, the nature of fixed income securities at the most fundamental level makes this point obvious. In the Champion International, we are using the S&P 500 as our market indicator. Equities are an entirely different form of security. They represent an ownership stake in the company; bonds merely represent an obligation on the part of the company to make a payment.
Thus, the sources of risk differ between bonds and stocks. Stocks have a much wider range of risks; bonds have only one – default risk. If a company is not profitable, this will have a negative impact on the share price. However, if the unprofitable company has strong liquidity, the impact of the operating loss will not be nearly as intense. The notion that bond prices can be equated to equity market performance is therefore absurd on even the most basic level. The basket of risk the two represent is entirely different, so it stands as no surprise that bond returns are unrelated to market returns.
The basic intellectual analysis, however, merely presents a hypothesis. In order to test this hypothesis, we must conduct an empirical test. The analysis of Vanguard funds should that bond portfolios are poorly correlated with the stock market (S&P 500). The correlation tends to become slightly stronger as the average maturity of the portfolio increases, however.
To determine whether or not the expected returns on corporate bonds can be explained solely by their systematic risk, we should analyze the relationship between bond returns and the market. The first step in this process is to gather historic return data from a wide range of bonds and from the market. The correlation between the two sets of data can be measure through regression analysis. What we see with respect to the Vanguard data set is poor correlation – a beta of .1579.
Using CAPM, this is applied to the market risk premium, and then added to the risk free rate. The result of this calculation is a cost of debt of 5.081%. Because this has been shown to be poorly correlated with the market, we can infer that the majority of this cost of debt reflects the prevailing risk free rate. Thus, it is the prevailing interest rate today that is the biggest determinant of the cost of debt.
This also explains why as the average maturity in a bond portfolio increases, the correlation with the market increases. While the correlation remains weak, we can see that for longer-term portfolios, the beta is significantly higher. The bond yield curve tells us that longer-term bond yields are less correlated to the risk free rate than are short-term bond yields. We understand that time to maturity is a significant factor in determining the relationship of bond yields and the prevailing risk free rate. This is because the greater the time to maturity, the more opportunity there is for interest rates to change, and to do with greater intensity.
Gebhardt, et al. (2004) show that market risk nonetheless remains a factor in the expected return on corporate bonds. In deconstructing the default risk of a bond, it should be noted that market risk does play a role. To the extent that the issuer’s financial health is determined by the market, the default risk will be related to market performance in some way. This does not mean that the beta for the company’s stock will be the same as the beta for the company’s bond, but there will be some degree of correlation between the two. This explains the fact that there are betas on bonds, for example the ones founds on the Vanguard funds. The betas may not be strong, and most certainly cannot be relied upon to estimate the expected return of the bond, but they are as suggested by Gebhardt a component.
To determine the degree to which the bonds of a single company, for example Champion International, are correlated with the market, we must follow the same method as was used for the Vanguard portfolios. The returns on the different Champion bonds must be gathered, as much the returns on the market for the time period studied. We are seeking to determine a beta for the debt. A regression analysis will reveal this beta. The beta will then be applied within the context of CAPM, to give an expected return.
When the beta is very low, this indicates that idiosyncratic risk is more important in explaining the expected return of the bond. The expected risk, as derived from CAPM, should be evaluated against the expected yield of the bond as priced by the open market. The degree to which the expected yield differs from the expected return as calculated using CAPM will indicate the degree to which beta is a reliable measure of expected returns. Because we know that systematic risk is a poor method of understanding expected bond returns, we should expect to find that the market yield of the Champion bond is not the same as what would be derived using the beta-based capital asset pricing model.
1) Maturity impacts corporate bond prices by moving them further from the face value. The time value of the volatility is greater as the maturity is longer. The time value of a bond’s cash flows is more likely to shift, and in greater intensity, the farther away the maturity is. This is because the largest flow, which is the face value, is moved farther in time. The risk therefore increases as the maturity is farther out. The result is that bond prices are typically decline as the maturity increases, in order to account for the risk represented by time value.
2) A bond is priced based on the expected value of the cash flows, adjusted for time value. Therefore, taxes are incorporated into that calculation. Taxes account for a portion of the spread between corporate bonds and treasuries, because taxes affect the value of the payments that are received. As taxes increase, the price of the bond should decrease, in order to maintain yield.
3) Liquidity is part of a bond’s risk. A highly liquid bond bears less risk, because the owner can easily sell it. An illiquid bond, however, is riskier because the owner may not be able to sell it. Short maturity bonds tend to be more liquid than long maturity bonds. As liquidity increases, the bond price should increase as well. This is because the bond does not need to give as much yield, because the risk is lower.
4) Recovery rates reflect the risk associated with default, in terms of the amount a bond-holder can expect to receive on the dollar of their investment. The higher the recovery rate, the lower the risk of the bond. This means that as recovery rates rise, bond prices should rise and yields would fall. A bond in a class with a poor recovery rate is may not be more likely to default, but the degree of damage associated with default is higher.
5) Bond ratings reflect risk. The better the rating; the lower the risk. Therefore, if a company’s bond rating improves, the price will increase. This will bring the yield into a new equilibrium. The less risky the bond, the lower the yield required. Conversely, if the rating is cut, then the bond price will drop in order to provide a higher yield on the bond, better reflecting its new risk level.
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