Financial Daily from THE HINDU group of publications
Sunday, Jul 25, 2004
Financial Daily from THE HINDU group of publications Sunday, Jul 25, 2004 |
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Investment World
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Corporate Bonds Money & Banking - Corporate Bonds Columns - Simple Economics Lowering risk through credit spread warrants B. Venkatesh
Suppose your company plans to issue bonds next June. You believe that the credit spreads are low now and will widen by June next. A credit spread refers to the difference in interest rate between a corporate bond and a comparable maturity government bond. Suppose interest rate on a five-year corporate bond is 6 per cent and that on a five-year government bond is 5 per cent. The interest on corporate bond consists of a risk-free rate of 5 per cent plus a credit spread of 1 per cent. Credit spread is the compensation paid to investors for the risk of default in interest and principal payments. What if the credit spread rises to 2 per cent next June? Your company will have to pay 7 per cent on its bonds. It can protect itself from widening credit spread by issuing credit spread warrants now. Assume your company promises investors to sell bonds next June at risk-free rate plus 1.25 per cent. In return, investors now pay your company 0.15 per cent of the bond's face value as premium. The investors will buy the bonds next June if the credit spread is lower than 1.25 per cent. Why? Suppose the credit spread is 0.75 per cent. Your company can issue the bond at 5.75 per cent. But it has promised to pay 5 plus 1.25 per cent. What if the spread is more than 1.25 per cent? Investors will not buy the bond. But your company now has to raise money at 7 per cent. It will use the premiums collected from investors to lower its interest cost. This product is essentially a credit-spread option.
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