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

  • Wealth Management Systems Inc. Financial Communications
  • Corporate Debt
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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. And since 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 U.S. Treasury yields and interest rate benchmarks such as Moody's seasoned bond yields, all of which are available daily from the website of the Federal Reserve Board of Governors. 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 one-and-one-half points (for Baa bonds) since 1994. But there were periods during the past two decades when the premium ran as high as two points or more for the top-grade Aaa bonds, and five-and-one-third points for the lower-grade Baa bonds.1

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 ended 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, 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, 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, passive bond investors' objective 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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Article copyright 2014 by Wealth Management Systems Inc. Reprinted with permission from Wealth Management Systems Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.
1Source: Federal Reserve Board of Governors H.15 reports, retrieved on March 26, 2014 and April 29, 2014.
2Source: fixedincome.fidelity.com, retrieved on March 26, 2014.
3Source: Standard & Poor's Capital IQ, 2013 Annual Global Corporate Default Study and Rating Transitions, March 19, 2014.
4Source: Standard & Poor's Capital IQ, Recovery Study (U.S.): Are Second Liens and Senior Unsecured Bonds Losing Ground As Recoveries Climb? December 16, 2013.
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