Vince Bellino ’15, Staff Writer
A corporate bond is a debt security that provides the issuing company with capital from investors as a means to finance various projects. In return, the investor receives a stream of cash flows called coupon payments plus their initial investment (principal) at maturity. Similar to how individuals are rated based on their FICO scores, a corporate bond is rated by agencies such as Moody’s, Fitch, or S&P to identify the credit worthiness of the company. Bonds are categorized in two ways: investment grade and high yield. An investment grade bond is one that has a good credit rating (AAA) and a low risk of default, which will therefore pay a lower interest rate or coupon. These are fundamentally sound companies that produce steady, reliable cash flows that exceed their interest payment requirements. A high yield bond also known as a “junk bond”, has a poor credit rating (D), with a relatively higher risk of bankruptcy. These are companies that are typically characterized as having less consistent cash flows or may be in more volatile industries such as telecommunication or energy.
So, how does one hedge their exposure to a high yield bond? Well, hedging is a way for an investor to reduce the risk of abnormal movements in one’s investment. Through financial engineering the market place has a structured derivative called a credit default swap. A credit default swap is essentially insurance on a company’s debt. It is a way to insure that an investor will not completely lose their investment in the corporate bond in the event of default. They trade in the over the counter market (OTC), which is a marketplace without a central location allowing market participants to trade with each other. The basic dynamic of this complex credit derivative is as follows: An investor in a corporate bond buys a CDS. The investor pays annual payments to the CDS seller. In the event that the company defaults, the investor receives a payout on an agreed amount, based on the investor’s loss. If the company does not default, then the investor continues to pay the annual payments until its expiration. So, a prudent investor who is less risk averse may buy a credit default swap to hedge their exposure to a high yielding corporate bond.