Money & Morals: Finance From the Founding Fathers to Junk Bond Traders (1998)

• published: 04 Aug 2015
• views: 12

The holder of any debt is subject to interest rate risk and credit risk, inflationary risk, currency risk, duration risk, convexity risk, repayment of principal risk, streaming income risk, liquidity risk, default risk, maturity risk, reinvestment risk, market risk, political risk, and taxation adjustment risk. Interest rate risk refers to the risk of the market value of a bond changing due to changes in the structure or level of interest rates or credit spreads or risk premiums. The credit risk of a high-yield bond refers to the probability and probable loss upon a credit event (i.e., the obligor defaults on scheduled payments or files for bankruptcy, or the bond is restructured), or a credit quality change is issued by a rating agency including Fitch, Moody's, or Standard & Poors. A credit rating agency attempts to describe the risk with a credit rating such as AAA. In North America, the five major agencies are Standard and Poor's, Moody's, Fitch Ratings, Dominion Bond Rating Service and A.M. Best. Bonds in other countries may be rated by US rating agencies or by local credit rating agencies. Rating scales vary; the most popular scale uses (in order of increasing risk) ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, with the additional rating D for debt already in arrears. Government bonds and bonds issued by government-sponsored enterprises (GSEs) are often considered to be in a zero-risk category above AAA; and categories like AA and A may sometimes be split into finer subdivisions like "AA−" or "AA+". Bonds rated BBB− and higher are called investment grade bonds. Bonds rated lower than investment grade on their date of issue are called speculative grade bonds, or colloquially as "junk" bonds. The lower-rated debt typically offers a higher yield, making speculative bonds attractive investment vehicles for certain types of portfolios and strategies. Many pension funds and other investors (banks, insurance companies), however, are prohibited in their by-laws from investing in bonds which have ratings below a particular level. As a result, the lower-rated securities have a different investor base than investment-grade bonds. The value of speculative bonds is affected to a higher degree than investment grade bonds by the possibility of default. For example, in a recession interest rates may drop, and the drop in interest rates tends to increase the value of investment grade bonds; however, a recession tends to increase the possibility of default in speculative-grade bonds. On March 23, 2009, U.S. Treasury Secretary Timothy Geithner announced a Public-Private Investment Partnership (PPIP) to buy toxic assets from banks' balance sheets. The major stock market indexes in the United States rallied on the day of the announcement rising by over six percent with the shares of bank stocks leading the way.[7] PPIP has two primary programs. The Legacy Loans Program will attempt to buy residential loans from banks' balance sheets. The Federal Deposit Insurance Corporation will provide non-recourse loan guarantees for up to 85 percent of the purchase price of legacy loans. Private sector asset managers and the U.S. Treasury will provide the remaining assets. The second program is called the legacy securities program which will buy mortgage backed securities (RMBS) that were originally rated AAA and commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS) which are rated AAA. The funds will come in many instances in equal parts from the U.S. Treasury's Troubled Asset Relief Program monies, private investors, and from loans from the Federal Reserve's Term Asset Lending Facility (TALF). The initial size of the Public Private Investment Partnership is projected to be $500 billion.[8] Nobel Prize–winning economist Paul Krugman has been very critical of this program arguing the non-recourse loans lead to a hidden subsidy that will be split by asset managers, banks' shareholders and creditors.[9] Banking analyst Meredith Whitney argues that banks will not sell bad assets at fair market values because they are reluctant to take asset write downs.[10] Removing toxic assets would also reduce the volatility of banks' stock prices. Because stock is akin to a call option on a firm's assets, this lost volatility will hurt the stock price of distressed banks. Therefore, such banks will only sell toxic assets at above market prices. https://en.wikipedia.org/wiki/High-yield_debt