Bonds are a vital part of any effective investment portfolio, providing stable cash flow. Despite their generally secure returns, bonds come with risks, primarily default and credit risks. Even sovereign bonds can face bankruptcy risks, making it crucial to assess these risks before investing. Understanding these risks helps investors make informed decisions and manage their portfolios effectively.
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Default risk is the probability that the bond issuer might fail to make the required payments of its principle or interest. For bond investors, default risk implies not only a potential loss on investment but also an unexpected disturbance of a fixed income. Default risk can be affected by many factors, such as recessions, inflations, and company management.
Evaluating the default risk of bonds requires a thorough analysis of the issuer’s financial health and market conditions. Key steps include:
Defaulting on bonds imposes significant negative consequences for both borrowers and lenders. For lenders, defaults on loans can lead to the loss of principal and interest, disruption of stable cash flows, and increased collection costs. Most notably, a significant disruption in cash flow can trigger a chain reaction, causing successive defaults among interconnected firms. In modern finance, firms often rely on stable income from financial instruments to service their debts and operational costs. Consequently, when a firm underperforms and coincidentally defaults on its loans, it increases the likelihood of default among other firms within the network.
For borrowers, failure to meet payment obligations results in a substantial decline in credit ratings and potential legal action from lenders. A significant drop in credit rating leads to higher borrowing costs in the future due to increased yields demanded by investors. If lenders pursue legal action, the borrower’s assets may be frozen, and in severe cases, the firm may face enforcement actions, further exacerbating its financial instability.
Credit default risk is a specific aspect of credit risk, focusing on the likelihood that a borrower will default on debt obligations. It is a critical consideration for various credit instruments, including bonds. While credit risk encompasses all potential risks of non-payment, credit default risk zeroes in on the actual event of default. This distinction is essential for investors as it helps them evaluate the severity and immediacy of potential losses.
Credit risk is a broader category that includes all risks associated with non-payment, such as exposure risk and recovery risk. Default risk, however, specifically relates to the event of default. While all default risks are credit risks, not all credit risks result in default. This differentiation allows investors to understand and manage various dimensions of risk within their portfolios.
Effective strategies for managing and mitigating credit and default risks include:
For example, obtain the credit rating of ordinary corporate bonds and other relevant information to understand the creditworthiness of the borrower. Convertible corporate bonds usually do not require a credit rating because they have the right to convert into stocks. Therefore, using the rating of the bond issuer can also be used as a way to evaluate the credit status of the bond. As the best financial database in Taiwan, TEJ has developed TCRI (Taiwan Corporate Credit Risk Index), which provides credit risk assessment indicators for publicly issued non-financial institutions in Taiwan. It is a credit assessment tool for convertible corporate bond issuers trusted by Taiwanese investors.
Diversifying your investment into different underlying assets helps lower exposure risk, moving the efficient frontier of your portfolio to the left, thereby getting a greater return under the same risk.
For example, to prevent potential loss from bond defaults, credit default swaps (CDS) transfer the risk to the seller of the CDS. CDS works the same way as an insurance policy. The seller of the CDS agrees to reimburse the buyer once the bond defaults, while the buyer only has to pay a fixed amount upon purchase.
The collapse of Silicon Valley Bank (SVB) serves as a great example. Although investing in a bond is certain to profit as long as the bond doesn’t default, the price of the bond will still fluctuate relative to the changes in interest rates. Hence, during the interest-rate hike in 2023, SVB displayed a great loss in bond investment on their financial statement; however, as long as the bonds are held to maturity, the loss would not appear. Unfortunately, the loss suggests too much exposure risk in bonds, causing a bank run, which later on forced the bank to sell the bonds for quick cash, thereby realizing the loss on the bonds.
TEJ provides invaluable resources for assessing bond investments and managing portfolio risk, including issue information and market data. Besides, TCRI(Taiwan Corporate Credit Risk Index) is specifically tailored for the Taiwanese market to objective and impartial assessment of corporate credit risks.
Based on a quantitative model and supplemented by professional manual interpretation. TCRI index is widely recognized by most financial institutions due to its high degree of differentiation, volatility and stability, and its ability to be compared with large international credit rating agencies. At present, TCRI has become an important reference indicator for more than 90% of Taiwan investment institutions to measure corporate and bond credit risks.
Reaching out to TEJ for Bond issue information and credit risk solutions, Our expertise ensures that your investment decisions are informed and your portfolio is well-protected against default and credit risks.
