Handbook of Finance: Investment Management and Financial Management

Chapter 49. Maturity, Capital Structure, and Credit Risk: Important Relationships for Portfolio Managers

STEVEN I. DYM, PhD

President, Mariner Capital Partners

Abstract: Treasury bond prices are sensitive only to interest rate movements, since they have no credit component. The longer the maturity (duration), the greater the price sensitivity. Corporate bond prices respond to interest rate movements, but to changes in default likelihood as well. A firm's likelihood of default is intimately related to the returns it earns on its assets. Low to negative earnings (return on assets) imperil a company's ability to service debt, hence affecting corporate bond prices. The level of seniority of a company's debt instruments determines the degree of responsiveness to the firm's earnings movements, with bonds on the lower end of the firm's capital hierarchy being more sensitive. This sensitivity is highly nonlinear. Credit default swaps compensate debt holders in the event of default, hence they show greater correlation with subordinated debt.

Keywords: corporate securities, debt, equity, seniority, maturity, credit risk, capital structure, earnings, asset value, book value, credit derivative, return on assets, bond price formula, nonlinear sensitivity, macroeconomic shocks, yield curve shifts, nonparallel shifts, Treasury securities, interest rate risk, corporate bond, credit default swap, bankruptcy, subordination, recovery value, correlation, hedge ratio, duration

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