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Outline event risk and the circumstances in which it may materialise for corporate bonds.

FRM® Part I · Financial Markets and Products · Corporate Bonds · FRM1.FM.17.e

The idea

Event risk is the risk that a sudden, unexpected event sharply lowers an issuer's credit quality and so the value of its bonds, whatever the company's earlier rating or history. Typical triggers include a leveraged buyout or takeover financed with debt, a leveraged recapitalisation, or a large debt-financed share repurchase or special dividend. Others are a merger or spin-off that moves assets away from bondholders, a natural disaster or industrial accident, an accounting scandal, or an adverse regulatory or legal change. The bond's spread widens at once and the price drops, and a downgrade often follows. Investors protect themselves with covenants. The notable one is a change-of-control or poison put, which lets holders sell the bonds back, usually at par or slightly above. Event risk is a discrete shock to credit quality, not a gradual drift in interest rates or the ordinary cycle of spreads.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which statement defines event risk for corporate bonds?

  1. The risk that a sudden event sharply cuts an issuer's credit quality and bond value. - correct
  2. The risk that interest rates rise gradually and reduce the value of fixed-coupon bonds.Why not: Describes interest rate risk, a gradual market-wide effect, not a discrete issuer event.
  3. The risk that the issuer calls the bond early when interest rates fall.Why not: Describes call risk, which is an issuer redemption option, not a credit event.
  4. The risk that a bond cannot be sold quickly without a large price concession to the buyer.Why not: Describes liquidity risk, which is about trading cost, not a credit shock.

Event risk is a discrete shock to an issuer's credit quality, such as a debt-financed takeover, which hits bondholders even when the issuer's earlier record was strong.

A harder one

A utility's bonds trade at tight spreads until a competitor announces a hostile takeover to be financed mainly by new debt. The bonds fall sharply, and the rating agencies put the utility on review for downgrade. The loss is best classified as:

  1. Interest rate risk, because the bond prices fell across the board after the announcement.Why not: Price falls from rate moves are market-wide; this loss is specific to the issuer's action.
  2. Event risk, as a sudden corporate action has weakened existing holders' credit. - correct
  3. Prepayment risk, because the takeover will accelerate repayment.Why not: Prepayment risk relates to early principal repayments, not credit deterioration.
  4. Reinvestment risk, because the cash flows cannot be reinvested at the old yield.Why not: Reinvestment risk concerns coupon proceeds, not a sudden credit shock.

The leveraged takeover is an abrupt event that raises debt and lowers credit quality for existing holders. It shows up as spread widening and a price fall: event risk.

The hardest tier

Following the announcement of a leveraged buyout, a bond with modified duration 6.5 and convexity 55 sees its spread widen by 200 bp (Treasury yields unchanged). Using duration and convexity, what is the approximate percentage price change?

  1. -13.00%Why not: Uses duration only and omits the convexity term, which offsets part of the fall.
  2. -14.10%Why not: Subtracts the convexity term instead of adding it; convexity reduces the loss from a rise in yield.
  3. -11.90% - correct
  4. -16.25%Why not: Uses a 250 bp widening instead of the 200 bp in the stem.

Price change = -D x dy + 0.5 x C x dy² = -6.5 x 0.02 + 0.5 x 55 x 0.0004 = -0.130 + 0.011 = -11.90%.

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