Bond issuers' default probability and its reflection in their coupon rate

Abstract

Purpose: The purpose of this study was to analyse whether local corporate bond issuers incorporated an appropriate premium for credit risk in their coupon rate. This was done through the computation of the risk neutral default intensity of each issuer, which was then analysed in relation to the bond's official coupon rate to see whether issuers ranked in the same place. This was further supported through a ratio analysis which was then converted into a score, by means of a scorecard, and ranked to allow direct comparability to the rankings given previously. Design: The objectives of this study were accomplished through the use of secondary research obtained from the issuers' Prospectus, Annual Reports, Rizzo, Farrugia & Co. (Stockbrokers) Ltd price archive and Central Bank of Malta MGS archive. Findings: The study revealed that the issuers rank as per the risk neutral default intensity was equivalent to the rank given according to their coupon rate. This, however, excluded International Hotel Investments Plc and Simonds Farsons Cisk Plc. On the other hand, the scorecard revealed that only Simonds Farsons Cisk Plc had a rank equivalent to the one obtained from the issuers' coupon rate rank, with the rest obtaining a completely different rank compared to that obtained from the other two ranks. Conclusion: Overall, the research shows that credit risk, as per the risk neutral default intensity, seems to be appropriately incorporated in the coupon rate. However, the coupon rate still includes other types of risk which the investor seeks compensation for, which haven't been considered in this study. Value: This type of study, the first of its kind, hopes to bring awareness to the importance of credit risk, for both issuers and investors. Credit risk awareness is becoming even more important nowadays, given the current financial state and as a result, the public should be aware of the credit risk inherent to a particular issuer, and issuers should make it a priority to quantify credit risk, whether it be though a rating issued by Credit Rating Agencies or any other method such as that used in this study.