Impact of Rising Default Risk on Corporate Bond Prices: Short-term vs. Long-term

Introduction

When a corporate bond faces a rising risk of default, it is natural to wonder how this risk affects the bond's price, particularly whether short-term or long-term bonds are more impacted. This article will delve into the dynamics of bond pricing under default risk, providing insights into how different maturity levels are affected.

Understanding the Maturity Impact on Bond Pricing

The impact of rising default risk on corporate bonds can vary by maturity. Assuming the company is not at the brink of default, a perceived decline in credit quality that might prompt a credit downgrade but not a default, the bond with a longer maturity is likely to experience a greater price drop. This is due to the increased risk premium required to hold the bond until maturity.

Increased Risk Premium for Long-term Bonds

Terje Johan Abrahamsen's Inscription: Terje Johan Abrahamsen’s analysis accurately notes that long-term bonds will drop more than short-term bonds. This is because the longer the bond's maturity, the higher the risk premium required to offset the increased risk of default. Short-term bonds, on the other hand, are less affected by the same risk as they have a higher likelihood of maturing without any significant negative credit event.

Example of a Downgrade Scenario: Consider a bond rated AA that has been downgraded to A. Although the new rating technically increases the default risk, it still qualifies as an investment-grade investment. Consequently, the bond's price will drop, but longer-dated maturities will be hit harder. The logic behind this is that the longer a bond remains, the higher the chance of experiencing a default event, whereas short-term bonds have a lower probability of defaulting before maturity.

Convergence to Par Value

Concept of Par Value at Maturity: It is important to understand that the price of a bond does not remain static, especially as it approaches maturity. As a bond moves closer to its maturity date, its price typically converges towards its par value. This is why the short-term bonds are less affected by default risk; their prices are already closer to par value, making them less susceptible to large price drops.

Recovery in the Event of Default

Impact on Recovery Timing: If the bond issuer does default, the time to maturity of the bond becomes irrelevant in terms of recovery. What matters then is the position of the bond in the capital structure. Secured debt has a higher priority over unsecured debt. In the event of default, secured debtholders are more likely to be paid, while bondholders with no security interest are paid last.

Trading of Distressed Debt

Different Market Dynamics: Bonds of entities in default may continue to trade as distressed debt, but this is a completely different market dynamic. Distressed debt trades based on the perceived recovery value of the bond rather than its face value. In such cases, the market dynamics can differ significantly from tradable corporate bonds.

Key Takeaways

This article has examined the impact of rising default risk on corporate bond prices, distinguishing between short-term and long-term bonds. The price drop is more pronounced for long-term bonds due to the increased risk premium required to hold them until maturity. However, in the event of a default, factors such as the bond's position in the capital structure determine recovery prospects, regardless of the time to maturity.

By understanding these distinctions, investors can make more informed decisions in managing their corporate bond portfolios.

Keywords: corporate bonds, default risk, bond pricing