Use Bond Risk Premiums to Identify Risky Debtors

As Enron’s stock price action illustrates, word of a company’s troubles often leaks out to investors before analysts change their ratings. Just as stock prices sometimes move ahead of news, bond prices may also signal changes in a company’s outlook before the news is reflected in the bond ratings. In those instances, bond investors will demand a higher bond yield, or a risk premium, to compensate for the added risk before they’ll buy a company’s bonds. Thus, checking a company’s bond risk premiums could hint toward potential financial problems.

For instance, Kmart finally threw in the towel and filed bankruptcy in early 2002, but its bonds traded at close to a 3 percent risk premium during all ...

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