Low-rated bonds: what an investor needs to know

A bond is a debt security that requires repayment of funds within a set period of time, and until then involves coupon payments.

The main characteristics of bonds are contained in the prospectus, a special document that is developed by a company before offering its bonds to investors. An investor can find out from the prospectus the nominal value of the bond, the size and frequency of coupon payments, as well as the issue and maturity dates, including the terms of early redemption – offer.

On the offer date, the investor has an opportunity to return his bonds for payment before the full maturity date, but this is his right, not an obligation.

What is the bond yield made up of?

Income on bonds can be made up of two components:

1. Coupon income is a percentage of the nominal value of the bond, which the issuer pays to the investor for the use of his money. Coupon income can be paid annually, semi-annually or quarterly.
2. Change in market price – if the market price of the bond rises, the investor will be able to sell it for more than they bought it for. However, it is important to remember that the market price of a bond can rise as well as fall, so this factor cannot always be controlled.

Bonds can be bought either directly from the issuer in the process of their placement, or from other traders on the stock or over-the-counter markets.

When purchasing bonds, the investor must pay the face value if buying them from the issuer, or the market price in the case of an exchange transaction. Bond prices are expressed as a percentage of the par value, which is always 1,000 units of the currency in which they are issued. For example, if the price of a bond in roubles is 85.3%, it means that you will have to pay 853 roubles for it, which is 85.3% of the par value. Bonds can be independent of rubles, and the issuer himself chooses the currency needed to raise funds. This can be dollars, euros, yuan and many other currencies; bonds in foreign currencies are usually referred to as Eurobonds, even if they are issued in other currencies.

When evaluating the merits of investing in bonds, buyers focus on the size of coupon payments, accrued coupon income (ACI) and maturity – all of which affect potential returns. Coupon payments are in the investor’s favour, as the issuer regularly transfers predetermined amounts to the bondholder at maturity dates. Therefore, in bond transactions, the buyer must compensate the seller not only for the cost of the bond itself, but also for the accumulated coupon income, which is formed since the last coupon redemption.

If a bond is purchased on the OTC market, the price does not depend on market conditions, but is calculated according to the following formula:

(purchase price × par value + NCD) × number of bonds + brokerage commission + depositary commission.

What are bond risks?

Risks on bonds can be divided into three groups:

1. Credit risks are the risks that the bond issuer will not be able to pay coupon income or repay the nominal value of the bond. Credit risks depend on the issuer’s credit rating: the lower the rating, the higher the risks.
2. Market risks are the risks of changes in the market price of the bond. Market risks depend on many factors, such as economic situation, interest rates, inflation and others.
3. Country risks are the probability that the government will not be able to fulfil its obligations to pay interest and principal on the bond. This risk is related to political, economic and financial factors that may affect the government’s ability to meet its obligations.

Let us now describe each risk in more detail

Credit risk

The risks of investing in bonds are similar to those of other securities and have different manifestations. The main among them is the credit risk associated with the possible deterioration of the issuer’s financial position, which may lead to:

• non-payment or delay in coupon payments;
• failure to return the face value upon maturity;
• cancellation of any settlements;
• request for instalment payments;
• failure to comply with the terms of early repayment;
• initiation of the debt restructuring process.

The reliability of a company can be determined based on its credit rating.

A credit rating is an assessment of an issuer’s ability to fulfil its financial obligations and the probability of its bankruptcy by a specialised rating agency. This rating helps investors to determine the financial stability of both the country as a whole and individual companies, as well as to assess the risks associated with specific bond issues, if they are rated. Consequently, the credit rating serves as an indicator of the credit risk of the issuer and its securities.

Rating agencies are independent structures that assess financial stability according to a variety of criteria and their own methods. They assess bond issuers and companies responsible for fulfilling international bond obligations, using both public and secret information.

The Bank of Russia controls the methodologies and also maintains a register of rating agencies, in which four Russian agencies are currently registered: Expert RA, ACRA, NKR and NRA. Each has its own rating system, and ratings can vary, even for different issues of the same company.

Special symbols – combinations of letters and numbers – are used to indicate the reliability level. Ratings, as a rule, go from A in descending order (AAA, AA, AA, A+, A, A-, BBB, BBB+, BB, BB-, CCC and so on). A ratings are assigned to the most reliable issuers, such as government or large companies, with high liquidity and minimal risk.

Yields on this type of bonds usually correspond to the levels of bank deposits, but they are characterised by low risk and high liquidity – they can be quickly bought or sold on the financial market.

Category B rating indicates an average degree of reliability. Such rating is often assigned to large corporate issuers with a positive history of doing business and previous payments. The investor can count on the return of his funds, although the financial risks of such issuers are somewhat higher. In this regard, the yield of corporate bonds is higher – for example, if the yield of OFZ is 8%, the same indicator for a corporate bond can reach 14%. It is important to take into account that the stated yield is not guaranteed and may turn out to be lower.

For foreign bonds, a rating of B or higher tells the investor that the issuer is able to meet its obligations despite possible restrictions from foreign regulators.

Rating levels belonging to the ‘investment grade’ categories include bonds with AAA and BBB ratings, which are typically characterised by high liquidity and active trading on an exchange. This means that such bonds can be bought or sold quickly due to the large number of offers in the market, resulting in a narrow spread between buy and sell prices.

A category C rating is defined as ‘speculative’, which indicates a company’s increased exposure to market fluctuations and unclear financial stability, or that the company has just started operations and has not had time to establish itself. Investors face a high risk of default on bonds in this category, but companies offer higher returns for this.

The lowest category D or default rating is assigned to issuers that are already having difficulty meeting their obligations. In addition, there are bonds without a rating, which indicates that their credit risk has not been assessed by any agency.

The absence of a rating on a bond does not necessarily indicate that it was issued by an unreliable company with financial difficulties. It simply means that information about the instrument is limited and the credit agency has not yet assessed the risks associated with the issue.

For this reason, transactions with unrated or low-rated bonds are mostly carried out by professional speculative traders. The liquidity of such bonds is low, which makes it difficult to buy or sell them, both Russian and foreign. Also, it is impossible to predict time frames of deals with such securities, as they depend on how quickly a buyer or seller will be found and what prices will be offered.

In addition, transactions with unrated foreign bonds may have restrictions from foreign regulators.

Market risk

The following risk does not depend on the financial condition of the issuer, which makes it relevant for both credit-rated and unrated securities.

This is the risk that the market value of a security will decline under the influence of various economic factors affecting investor sentiment. Such factors include changes in the key interest rate, the effects of pandemics, geopolitical conflicts, negative news and other circumstances.

All securities are equally exposed to market risk.

Main factors affecting market risk on bonds

1. Interest rates. Changes in interest rates in the market can significantly affect the market risk of bonds. If interest rates rise, the market value of previously issued fixed income bonds may decline as investors may choose to invest in higher yielding instruments. Conversely, when interest rates fall, the value of bonds may rise.
2. Maturity. The longer the term to maturity of a bond, the greater the market risk. This is due to the fact that over a long period of time, various events can occur that can affect the value of the bond.
3. Liquidity. The liquidity of a bond is the ability to sell the bond in the market quickly and without significant loss. Bonds with low liquidity may have higher market risk because they are more difficult to sell at a fair price.
4. Macroeconomic factors. Macroeconomic factors such as inflation, economic growth, political events and regulatory changes can also affect the market risk of a bond. These factors may result in changes in interest rates, credit risk and liquidity in the market.
5. Currency risk. If a bond is issued in a foreign currency, changes in the exchange rate of that currency may affect market risk.
6. Supply and demand. The number of buyers and sellers in the bond market also affects its market risk. If demand for a bond exceeds supply, its price may rise and vice versa.
7. Bond rating. A bond’s rating is an assessment of its credit risk assigned by rating agencies. The higher the rating, the lower the market risk. However, even bonds with a high rating can have market risk due to other factors.
8. Issuer Specific Risks. Specific risks associated with a particular bond issuer, such as changes in its financial position, can also affect the market risk of a bond.

Country risk

When acquiring Eurobonds issued by a foreign company, an investor must take into account the peculiarities of that country and the additional risks associated with them. A foreign company may have its own requirements regarding the issue or circulation of securities. In addition, the investor will have to resolve all disputes related to Eurobonds in the issuer’s country, which is also an important factor.

For example, if an investor acquires a Eurobond issued by a US or Russian company but regulated by foreign laws. In case this company fails to fulfil its financial obligations, i.e. fails to pay the coupon or the nominal value of the bond on its maturity date, a claim can be filed in the local jurisdiction of the issuer or in the place where the bond was issued, for example, in the USA. The investor also has the right to demand the fulfilment of obligations by making a claim in accordance with the legislation specified in the prospectus.

Main factors affecting country risk on bonds:

1. Political stability: an unstable political situation could lead to devaluation of the national currency, increased inflation, changes in legislation and other negative consequences that could affect the government’s ability to repay its bond debts.
2. Economic situation: economic crisis, increase in unemployment, decrease in GDP may lead to deterioration of the state’s financial position and reduce its ability to repay its bond debts.
3. Currency risk: a change in the exchange rate of the national currency may lead to a decrease in the value of bonds in foreign currency and an increase in the cost of servicing debt in national currency.
4. Sovereign default: a government’s refusal to honour its obligations under the bonds may cause investors to lose their funds.
5. Credit rating: the rating assigned by an international rating agency reflects the probability of default by the government and may affect the value of and yield on the bonds.

Taxation of bond income

Taxation of bond income depends on several factors:

Type of bond – if the bond is issued by a foreign company, its income may be subject to personal income tax (PIT).
Period of holding the bond – if the investor holds the bond for less than three years, the income on it may be subject to personal income tax at a higher rate.
Type of income – coupon income is usually subject to personal income tax at the standard rate, while changes in the market price of a bond may not be subject to personal income tax at all.

It is important to note that the taxation of bond income may change depending on changes in legislation and other factors. Therefore, it is recommended to follow the news and updates in this area.

It is important to remember that investing in bonds with a low rating is always associated with certain risks, so before making a decision to invest, it is necessary to carefully study information about the issuer and its financial position. It is also recommended to consult with a financial advisor or investment specialist.