Probability of default ^ bond rating

* 1-Y Probability of default (denoted PD) is defined for a single issuer. * Rating (like AA) is defined for one bond among many by the same issuer.

Jon Frye confirmed that an AA rating is not an expression of the firm’s status/viability/strength/health.

I guess the rating does convey something about the LossGivenDefault, another attributes of the bond not the issuer.

BUY a (low) interest rate = Borrow at a lock-in rate

Q: What does “buying at 2% interest rate” mean?

It’s good to get an intuitive and memorable short explanation.

Rule — Buying a 2% interest rate means borrowing at 2%.

Rule — there’s always a repayment period.

Rule — the 2% is a fixed rate not a floating rate. In a way, whenever you buy you buy with a fixed price. You could buy the “floating stream” …. but let’s not digress.

Real, personal, example — I “bought” my first mortgage at 1.18% for first year, locking in a low rate before it went up.

factors affecting bond sensitivity to IR

In this context, we are concerned with the current market value (eg a $9bn bond) and how this holding may devalue due to Rising interest rate for that particular maturity.

* lower (zero) coupon bonds are more sensitive. More of the cash flow occurs in the distant future, therefore subject to more discounting.

* longer bonds are more sensitive. More of the cashflow is “pushed” to the distant future.

* lower yield bonds are more sensitive. On the Price/yield curve, at the left side, the curve is steeper.

(I read the above on a slide by Investment Analytics.)

Note if we hold the bond to maturity, then the dollar value received on maturity is completely deterministic i.e. known in advance. There are 3 issues with this strategy:

1) if in the interim my bond’s MV drops badly, then this asset offers poor liquidity. I won’t have the flexibility to get contingency cash out of this asset.

1b) Let’s ignore credit risk in the bond itself. If this is a huge position (like 2 trillion) in the portfolio of a big organization (even for a sovereign fund), a MV drop could threaten the organization’s balance sheet, credit rating and borrowing cost. Put yourself in the shoes of a creditor. Fundamentally, the market and the creditors need to be assured that this borrower could safely liquidity part of this bond asset to meet contingent obligations.

Fundamental risk to the creditors – the borrower i.e. the bond holder could become insolvent before bond maturity, when the bond price recovers.

2) over a long horizon like 30Y, that fixed dollar amount may suffer unexpected higher inflation. I feel this issue tends to affect any long-horizon investment.

3) if in the near future interest rises sharply (hurting my MV), that means there are better ways to invest my $9bn.