Price Sensitivity: Credit Rating & Modified Duration

In the volatile market conditions the financial and economic environments have endured the past few months, it is important to evaluate Investment risks and sensitivities. Investors may assess bonds based on various factors, including interest rate movements, credit risk, and market conditions. US Treasury benchmarks are particularly influential, as their yields serve as a global benchmark for borrowing costs and economic outlook.

‍Understanding the relationship between sovereign bonds, US Treasury yields, credit ratings, and modified duration is insightful for evaluating risk and return in fixed-income investments.

This brief report explores the relationship of these factors, analyzing how US Treasury yields influence sovereign bond yields, the role of credit ratings in determining bond risk, and how modified duration measures a bond’s sensitivity to interest rate changes. By examining these relationships, the report aims to provide insights into pricing, risk assessment, and investment strategies related to sovereign bonds in various market conditions.

In this report, we will observe how different rated long duration sovereign bonds react to changes in US benchmark rates. We will utilize bonds maturing in 2047 issued by the Kingdom of Bahrain, the Sultanate of Oman and the Kingdom of Saudi Arabia to illustrate the impacts mentioned alongside their behavior towards in conjunction with movements of the US 20-year treasury benchmark.

A bond's credit rating and modified duration are both key factors in assessing its risk and price sensitivity, but they measure different aspects of risk:

A bond's credit rating, assigned by agencies like Moody’s, S&P, and Fitch, reflects the issuer’s ability to meet debt obligations. Higher-rated bonds (e.g., AAA, AA) have a lower default risk, while lower-rated bonds (e.g., BB and below) are riskier but offer often offer higher yields.

Modified duration measures a bond’s sensitivity to interest rate changes. A higher duration means the bond’s price is more volatile when rates fluctuate. Longer-term bonds and lower-coupon bonds generally have higher modified durations. In this illustration the bond issued by the Kingdom of Bahrain has the lowest credit rating and modified duration, whereas the bond issued by the Kingdom of Saudi Arabia has the highest.

Line Graphs illustrating the relationship between the movements of the US 20 year treasury benchmark and the price of the bonds discussed :

As illustrated above, the higher rated Investment grade bonds had a higher price sensitivity to changes in US benchmark rates.

While the lower rated Bahrain bond maturing in 2047 offers a higher yield to maturity and coupon then the others discussed, the capacity and potential for capital appreciation is also more limited. We have remained in a higher rate environment in this post-covid economy that still seems to be stubbornly persisting.

Non-investment grade bonds (below BBB-, like Bahrain), also known as high-yield, carry greater credit risk due to their lower credit ratings. As a result, they are more sensitive to overall risk sentiment. When market confidence declines, investors tend to shift away from riskier assets, leading to widening credit spreads resulting in the decline of the value of these bonds.

Additionally, these bonds, especially those by issuers in commodity-dependent countries/sectors, are more vulnerable to fluctuations in commodity prices, as volatile price swings can impact issuers’ profitability and creditworthiness. This can consequently have an impact on the value of a lower rated non-investment grade bond.  

Unlike higher-rated bonds, non-investment grade bonds yields are primarily driven by credit risk rather than interest rate risk/benchmark yields.  Furthermore, lower-rated bonds exhibit greater sensitivity to market downturns and tightening financial conditions, as economic stress can amplify default risks and liquidity concerns, causing declines in their valuations.

While we cannot forecast the future nature of the economic and interest rate environment with any guarantees, scenarios illustrating the potential for capital growth in a lower interest rate environment demonstrate the significance of considering the factors such as a bonds modified duration, particularly in respect to the long end of the curve.

While we cannot forecast the future nature of the economic and interest rate environment with any guarantees, scenarios illustrating the potential for capital growth in a lower interest rate environment demonstrate the significance of considering the factors such as a bonds modified duration, particularly in respect to the long end of the curve.

During 2020, the US 20-year treasury benchmark was below 1.00%. Reverting to these levels may seem far-fetched, therefore if we forecast a more conservative low-interest rate environment between 3%, the results are as follows:

On a position of USD 500,000 the increase in principal value would be as follows:

While KSA 46’ did have the largest percentage increase in the scenario above, OMAN 47s principal value saw the largest appreciation. This is because the price of OMAN 47s increased by $22.158 in comparison to KSA 46s appreciation of $19.959.