Fixed Income Securities
Essay Preview: Fixed Income Securities
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As is the case for government and municipal bonds, the issuer of a corporate bond has the obligation to honor his commitments to the bondholder.
A failure to pay back interests or principal according to the terms of the agreement constitutes what is known as default. Basically, there are two sources of default. First, the shareholders of a
Fixed Income Securities
corporation can decide to break the debt contract. This comes from their limited liability status: they are liable of the corporations losses only up to their investment in it. They do not have to pay back their creditors when it affects their personal wealth. Second, creditors can prompt bankruptcy when specific debt protective clauses, known as covenants, are infringed.
Corporate bonds are said to be affected by default or credit risk. Their yields contain a default premium over Treasury bonds, accounting for total default or credit risk, as well as over swaps,3 accounting for specific default or credit risk. In case of default, there are typically three eventualities:
* First, default can lead to immediate bankruptcy. Depending on their debt securities seniority and face value, creditors are fully, partially or not paid back, thanks to the sale of the firms assets. The percentage of the interests and principal they receive, according to seniority, is called recovery rate.
* Second, default can result in a reorganization of the firm within a formal legal framework. For example, under Chapter 11 of the American law, corporations that are in default are granted a deadline so as to overcome their financial difficulties. This depends on the countrys legislation.
* Third, default can lead to an informal negotiation between shareholders and creditors. This results in an exchange offer through which shareholders propose to creditors the exchange of their old debt securities for a package of cash and newly issued securities.
We now refer the reader to Chapter 13 “Modeling the Credit Spreads Dynamics” for more infor- mation on the assessment of default.
The Corporate Bond Market
The Market Size In the context of a historically low level of interest rates, linked to a decreasing trend in inflation as well as in budget deficits, the corporate bond market