Use of options in assessing risky corporate debt


Assessing Risk Credit Risk You should assess the creditworthiness of a zero coupon municipal bond the same way you would any municipal security. For municipal bonds, credit risk is determined by the financial and operating stability of the state or local government entity that issued the bond or the entity that is obligated to pay the principal of and interest on the bonds.

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Virtually all new issues of municipal securities are originally offered by means of disclosure documents called official statements or offering circulars that describe in detail the financial condition of the issuer or the entity responsible for making payments on the bonds.

Bonds with lower ratings indicate a higher degree of risk. The rating agencies grade bonds according to their investment qualities but do not intend the rating to be the sole basis for an investment decision.

The ratings cannot, for example, forecast market trends. Before purchasing any bonds, particularly those with lower ratings, talk with your investment advisor to make sure they are suited for use of options in assessing risky corporate debt.

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Market Risk As with all fixed-income securities, the yields or interest rates on zero coupon municipal bonds fluctuate, usually in step with general market rates.

While the interest on a bond is fixed by the price you paid, newer bond issues may be offered at higher or lower rates depending on prevailing interest rates when they are issued.

Investors who buy corporate bonds are lending money to the company issuing the bond. In return, the company makes a legal commitment to pay interest on the principal and, in most cases, to return the principal when the bond comes due, or matures.

Like other bonds, the values of zero coupon municipal bonds move inversely to the movement of interest rates: bond values will increase as interest rates decline, and bond values will decrease as interest rates increase.

Zero coupon bonds are more sensitive to interest rate swings than bonds which pay interest semiannually because all the interest payments of zero coupon bonds are accumulated and paid at maturity.

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A coupon bond which pays interest semiannually loses its volatility as it draws closer to maturity because its true value to investors—interest—slowly dwindles as the number of interest payments left declines. The longer the maturity of a bond, the greater the volatility.

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Call Provisions Many municipal bond issues allow the issuer to call or redeem all or a use of options in assessing risky corporate debt of the bonds at a premium or at par before maturity. When investors purchase bonds, dealers will quote the yield to call date if it is less than the yield to maturity.

An accepted fact among investors is that the higher the returns on an investment, the higher the risks are. Safe investments carry low risk, but the returns are also lower. Different levels of risk apply to common and preferred stock, as well as to corporate bonds. Corporate bonds generally have the lowest level of risk of the three investment types, but also offer lower returns, in spite of regular dividend payments. Common stocks have the highest risk of the investments and the highest potential returns.

Therefore, an investor can know what the return on the bond will be if the issuer exercises its right to call the bonds. By providing this general information, the Securities Industry and Financial Markets Association makes neither a recommendation as to the appropriateness of investing in fixed-income securities nor is it providing any specific investment advice for any particular investor.

Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and sources may be required to make informed investment decisions.

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