Get to know the way bonds work: Price Risk Analysis and Failure to Pay Bonds

In the previous article we have known the basic concepts of bonds such as coupons, Yield to Maturity, and things that affect changes in bond prices. In this article, I will discuss further about analyzing bond risk. In general, the risk of bonds can be divided into 2, namely the risk of default and the risk of price changes.

Risk of Failure to Pay and the Measurement Method

Risk of Failure to Pay and the Measurement Method

In the mutual fund prospectus, especially those with a portfolio of bonds such as mixed, fixed income, money market and protected, the risk of default is also called credit risk. In English it is called default risk. Failure can be defined as the failure of a company to pay both its coupon and / or principal. Generally the risk of default is owned by a private company, but Greece’s defaults remind us that none is safe from these risks.

The obligation of the party issuing the bond (called an issuer or obligor) from a bond instrument issued to maturity is PAYING the coupon and the Bond Principal. Failure to pay off one of the obligations can lead to a company being sued or filing for bankruptcy. However, it is possible that a company that is experiencing financial difficulties can also restructure its debt. Examples of companies or even countries whose bonds fail to pay also have many examples that you can read in the mass media. For example, it has happened in one of the Tbk companies in Indonesia and Greece.

The size of the risk of default can be measured in several ways including:

  1. Rating Analysis
  2. Financial Ratio Analysis.

Well, specifically for the analysis of financial ratios this is actually very broad. But generally the analysis was developed by experts to predict or see whether a company has the possibility of default. Analysis method to predict whether a company is in a state of financial difficulties that can cause default, such as the Altman Z-Score method, covenant ratio analysis, and financial ratio analysis. The method above is quite simple and has proven to be quite effective several times in predicting the incidence of corporate defaults in Indonesia.

There is also another version of the method of bankruptcy analysis where with this method, it can be calculated what percentage of probability a company will experience conditions of default. This method generally uses 2 approaches, namely based on historical rating and statistical analysis. The approach to using historical ratings is generally used by rating companies. The method is also quite simple, the way companies compare between the number of companies that fail to pay and the total companies that get similar ratings. For example, out of 100 companies that get BBB ratings, 10 of them go bankrupt, then it can be said the default probability of a company that gets a BBB rating is 10%. In research conducted by PEFINDO, the way I illustrated above is also combined with time. For more details, you can read this link.

One disadvantage of using historical ratings as an indicator for determining bankruptcy probabilities is that they are too standardized for companies. Because sometimes, the consideration of a company getting a rating is not only quantitative but also gets qualitative consideration. For example, if 2 companies rated have more or less the same conditions, state-owned companies (SOEs) are likely to get a better rating than private companies.

A more objective method of calculating the probability of corporate bankruptcy because only considering quantitative factors (financial ratios) such as the KMV Merton method might be a complement of the above deficiencies. In simple terms, the KMV Merton method calculates a Z number based on existing financial ratios. The number is then using the normal distribution approach in statistics, translated into the percentage probability that a company will experience default. This method allows companies with the same rating to produce a different probability of default considering the financial statements of the two companies are definitely not exactly the same. The weakness of this method in my opinion is the lack of “common sense”. It could be that companies that have proven to be very solid, strong, but because of a corporate action or inefficient operation in some cases make the company have a higher probability of default than companies that are much smaller but more efficient.

In addition to the above methods, of course there are still other ways available such as using the option method and others. For academics or practitioners who are interested, you can use the method above as a consideration in investing in corporate bonds. Can also develop other, more effective ways to avoid Indonesian investors from buying bonds / bonds that fail to pay.

Risk of Price Fluctuations and Measurement Methods.

Risk of Price Fluctuations and Measurement Methods.

If you are a fixed income mutual fund investor and are keen enough to see price movements over the past 1-2 months, you certainly realize that mutual funds that invest in these bonds can go up and down. Even the decline can reach several percent. Because bond prices can go up or down, we need to understand how to calculate the risk of changes in bond prices. This risk is also often referred to as Market Risk.

The risk of bond movements is somewhat different from the risk of movements in stocks. The main difference is that bonds have a maturity period while stocks do not. The effect of this is how much the price of the bond moves, if there is no default, the bond will return at its nominal price. While the stock has no maturity, prices can move wildly out of control. Can reach the lowest possible price of IDR 50 and not return to the original price we bought or the IPO price. So the bonds’ losses will not be more loss than shares.

From the writing of the first edition, one of the factors that greatly influences bonds is the change in expectations of the expected rate of return. But we need to know, that bonds with longer maturities and bonds with shorter maturity, have different rates of price changes. The fast or slow return of capital from bond investment is determined by the size of the COUPON and the short length of TEMPO FALL TIME.

For example, a bond has a 5% coupon and a 10% coupon. Then mathematically, bonds with a 5% coupon will be more volatile than bonds with a 10% coupon. Because with a 5% coupon, a bond takes 20 years to repay, while with a coupon of 10%, enough 10 years can be returned. Another illustration, if both bonds have a 10% coupon, but one has a 5-year maturity while the other has a maturity of only 10 years, then the risk of price fluctuations will be greater in bonds with 10-year maturities and smaller bonds. 5 years maturity.

In financial terms, the risk of bond price fluctuations is called DURATION. Almost similar to the BETA concept in stocks and mutual funds. Duration is NOT due. Duration is a bond risk unit that shows how much changes in bond prices are due to changes in the expected level of expected profits. Regarding how to calculate the duration, you can see this website.

The way to read duration is the opposite. As an illustration of a bond has a duration 5. If interest rates rise, so the expected gain investor expectations UP 1%, it is predicted that the bonds will have a 5% DECREASE. Conversely, if interest rates go down, so that the expected investor expectations keuntunga DOWN 1%, it is predicted that the bonds will have a 5% INCREASE. The duration of the bond is called Long or Short, not large, small or high low.

In relation to the Duration with Coupons and Maturity, a bond that has a long duration if the Coupon is SMALL and / or the Fall Time is still LONG (Low Coupon and Long Maturity). While bonds are said to have a short duration if the coupon is BIG and the date is falling FAST (High Coupon and Short Maturity). Investopedia illustrates very well with this picture.

There are various durations. Macaulay Duration and Modified Duration is the duration most often used to express the risk of bonds. Effective Duration is used to express the risk of bonds with a put or call option. While Key Rate Duration is used in the analysis of return attribution for bond-based portfolios. In my view (using Modified Duration):

  • Duration 1 – 3 is called Small Risk
  • Duration 3 – 5 is called Intermediate Risk
  • Duration 5 is called High Risk

There are still not many, but I noticed that there are several Investment Managers who have included their duration portfolios in the fund fact sheet of the fixed income mutual funds they manage. This information is very useful for investors in seeing how much the risk of price fluctuations is owned by a fixed income mutual fund.

Thus sharing this time, may be useful and increase your knowledge in bond investment.

The mention of investment products (if any) does not mean to give a good bad rating, or a recommendation to buy or hold for certain instruments. The purpose of giving an example is to show facts that reinforce the opinion of the writer. Past Performance is not a guarantee that it will repeat itself in the future. All posts, comments and responses to comments are personal opinions.