Measuring risk in the fixed income market

Would you rather senior debt from a company with a higher probability of failing, or lower ranking debt from a better rated company?

Summary: When investing in fixed income, a senior secured lender ranks higher than a deeply subordinated bondholder should an issuer fail. It could be implied that investing in higher ranking bonds carries less risk. But this may be a secondary consideration.

Key take out: For many investors the primary consideration may be the probability of an issuer failing, and thus the risk adjusted return that is on offer.

Key beneficiaries: General investors. Category: Investment bonds.

In recent days articles have appeared in the financial media, examining the importance of fixed income investors understanding where they rank in the capital structure of a bond issuer. Put simply, a senior secured lender ranks at the top of the pile, while the holder of deeply subordinated bonds ranks just above the issuer’s shareholders and will be the next after the shareholders to see their investment wiped out, should the issuer fail.

These differences in ranking and risk are rewarded through the different returns that investors can expect to receive. The senior secured lender, typically a bank, will receive the lowest return, while a deeply subordinated bondholder might receive a return that is twice that to the senior secured lender, and a shareholder should receive the highest return by sharing in the profit of the company.

Thus, it could be implied that fixed income investors face less risk if they invest in senior ranking bonds, than if they invest in subordinated bonds. Yet the reality is that this is only a secondary consideration.

So let’s ask the question, would you rather buy a bank hybrid, say the recently issued NAB Capital Notes, or senior unsecured bonds issued by an unrated company, say those recently issued by McPherson Limited? By just considering the ranking of the debt in the capital structure of the two issuers, the senior ranking McPherson bonds may look more attractive.

However, the expected return to investors in the NAB Capital Notes is considerably higher than the expected return to McPherson bond holders. The expected return in this case is the risk adjusted return.

The expected return is calculated by adjusting the yield offered on the bonds to allow for the expected loss. The expected loss is the product of the probability of an issuer failing (the probability of default) and the loss incurred as a result of the issuer’s failure.

Thus, the ranking of a bond in the capital structure of an issuer only comes into play after the issuer has failed. Therefore, the primary consideration for an investor could be the probability of an issuer failing.

To assess the probability of failure, credit ratings are vitally important. The major credit rating agencies have a long history of company failures from which the probability of failure can be determined at each rating level.

Moody’s Investors Service has the longest such history, dating from 1913. Moody’s also has data from 1983 on the losses incurred by bondholders at different levels of an issuer’s capital structure, once default has occurred.

From this data an investor can calculate the expected loss from investing in bonds issued at any level in the capital structure of an issuer. And from there, it easy to calculate an investor’s risk adjusted return.

For the NAB Capital Notes the risk adjusted return is calculated as follows: 

  • The term to call for the Capital Notes is five years.
  • NAB is assessed as an ‘A’ category issuer on a stand-alone basis.
  • From Moody’s data, the average cumulative default rate for an ‘A’ category credit after five years is 1.379 per cent.
  • Moody’s data on loss given default shows that a subordinated bond holder can expect to lose 72 per cent of their investment on average.
  • Thus the expected loss for the NAB Capital Notes is 1.379 per cent x 72 per cent or 1 per cent.
  • If the expected loss is annualised and applied to the initial coupon set on the Capital Notes, the expected return is 5.57 per cent - 0.2 per cent or 5.37 per cent per annum (grossed-up for franking credits).
  • If a total loss is assumed on the failure of NAB, the expected loss is 1.379 per cent, which gives an expected return of 5.19 per cent per annum.

Now let’s look at the expected return for the senior unsecured bonds issued by McPherson Limited. The first problem encountered is that McPherson is unrated.

However, if McPherson is analysed through the rating model used by Australia Ratings, McPherson is assessed as being a ‘CCC’ category issuer. (This is a quantitative assessment with no consideration of qualitative factors.)

McPherson recently issued both four and six year bonds but not a five year bond, so an interpolated five year bond yield needs to be determined.

The four year bonds pay a margin of 440 basis points over the bank bill rate and the six year bonds offer a yield of 7.1 per cent per annum. If the margin on the four year bonds is applied to the four year swap rate at the time of issue, the resulting yield is 6.6 per cent per annum.

Thus the interpolated five year yield for McPherson Limited bonds is 6.85 per cent per annum. And the risk adjusted return for the five year bonds is calculated as follows:

  • From Moody’s data, the average cumulative default rate for a ‘CCC’ category credit after five years is 40.375 per cent.
  • Moody’s data on loss given default shows that a senior unsecured bond holder can expect to lose 52 per cent of their investment on average.
  • Thus the expected loss for the McPherson bonds is 40.375 per cent x 52 per cent or 21 per cent.
  • If the expected loss is annualised and applied to the five year yield, the expected return is 6.85 per cent - 4.2 per cent or 2.65 per cent per annum.

So would you rather buy a bank hybrid or senior unsecured bonds issued by an unrated company?

Well, if the bank hybrid is NAB’s Capital Notes and the senior unsecured bonds are those issued by McPherson Limited, then the expected return from NAB’s Capital Notes is far more attractive. For an investor to be indifferent between the two options, the McPherson bonds would have to yield at least 9.4 per cent per annum.

Thus, a fixed income investor’s position in the capital structure of a company may really be a secondary consideration. For many investors the primary consideration may be the probability of an issuer failing, and it is very hard to assess what the probability of failure is, if a company is not rated.    


Philip Bayley is a former director of Standard & Poor's and now works as an independent consultant to debt capital market participants. He also writes on matters concerning debt capital markets and banking for various publications and is associated with Australia Ratings.

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