Reality Check 2: Comparing market-derived and fundamentally derived values for bonds

The actual yield for any bond may vary noticeably from projections for that bond made using rating, category, and term averages

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A rose may be a rose, but a bond is not just a bond; every bond issue is materially different in some way from every other one. That is why every yield may be different, even when both come from the same issuer and even when they have similar surface features. And it is also why the actual yield for any bond may vary noticeably from projections for that bond made using rating, category, and term averages. Plus because the current yield (along with remaining term and expected redemption value) is a prime determinant of market price, it is also a major factor in investment total return.

In theory, a bond's yield can be expressed as the market's risk-free interest rate plus a risk premium. In practice, the general market yields and risk premiums for corporate bonds can be inferred using the US Treasury yields and interest rate benchmarks, such as Moody's seasoned bond yields. For example, taking the 20-year Treasury yield as the closest thing to a (credit) risk-free yield, along with the Moody's seasoned Baa and Aaa corporate yield benchmarks, the risk premium for long-term corporate bonds typically ranged from approximately one-half point (for Aaa bonds) to roughly 11/2points (for Baa bonds) since 1994. But there were periods during the past two decades when the premium ran as high as 2 points or more for the top-grade Aaa bonds, and 51/3 points for the lower-grade Baa bonds.1 Current interest rates are available on the Board of Governors of the Federal Reserve website.

But this average would not be generally meaningful for projecting the value of any particular bond. For example, call features and positions in the company's capital hierarchy can influence a bond's current market yield, as can market evaluations of risk. As a result, there can be wide variation among bonds with similar maturities and credit ratings. For example, on a randomly chosen day in early 2014 (March 26), Fidelity's retail bond dealing system showed nine Baa-rated bonds maturing in 20 to 25 years listed for sale. Current market yields for those bonds ranged from 4.66% to 6.58% based on their posted ask prices.2

There can be many reasons for any given bond's yield to deviate significantly from the norm for its quality class and term. Some of them have objective values in their own rights; others are more subjective and subject to wider ranges of individual interpretation. Many involve both types in combination. Here is a selected overview:

Default probability

One significant source of variation in bond values is the probability of default. Basic credit rating is one measure of default, according to Standard & Poor's. Between 1981 and 2013, no corporate bond carrying an AAA rating (the top of the S&P scale) has ever defaulted. And while there have been occasional defaults during the period among corporate bonds with lower investment-grade ratings, the cumulative default rate for AA-rated bonds over the five years ending December 31, 2013, was 0.0%; for BBB-rated bonds, it was 1%; and for BB-rated bonds, it was 3.4%. Among those companies that did decline into default (i.e., a D rating) during the 1981–2013 period, the average time to reach default from an AAA rating was 18.3 years; from a BBB rating, 7.7 years; and from a B rating, 3.4 years. As with other performance statistics, there has been meaningful variation within the averages. Individual calendar-year default rates on AA-rated bonds ranged from 0% to 0.38% between 1981 and 2013, and on BBB-rated bonds, from 0% to 1.01% over the same period. Among speculative bonds, defaults are predictably more common. For the B-rated bonds (those in the middle of the speculative category), the range of annual default rates was 0.25% to 13.84%.3

Recovery

Bondholders have historically received at least partial payments when bond issuers default. Since 1987, Standard & Poor's noted that the overall average rate of recovery on defaulted corporate bonds was about 51%, but there was a wide range of experiences, from a 33% average recovery in 1989 to a 72% rate in 2007. Secured bonds generally receive higher recoveries than unsecured bonds. Higher-rated bonds that entered default had generally higher recovery rates than lower-rated bonds (more than 60% for investment-grade bonds compared with less than 40% for speculative bonds). Moreover, in recent years, the balance of secured and unsecured bonds has changed. There are now relatively more secured bonds, so they are garnering a growing share of the capital available to investors for recovery from corporate default.4

Equity conversion rights

Recovery rates generally reflect the total value received after default, which may be in the form of cash, individual company assets, new debt, new equity, or some combination. In the typical recovery scenario, the objective of passive bond investors is liquidity and credit analysts can seek to estimate amounts likely to be available for recovery as a company approaches and then moves through the default process. But there have been cases where a major bondholders' ultimate objective may have been to gain control of a company through a court-sanctioned bond-to-stock conversion. In these cases, a prospective bondholders' takeover could change the recovery calculus.

While the primary features of fixed income instruments may make their valuation appear to be straightforward, there are notable extenuations for every valuation scenario. Before relying on any formulaic assessment, it is important to be sure that all circumstances can be clearly understood and evaluated.

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