Concept
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The way that the bond markets incorporate default risk into bond prices makes the dynamics of default-able bonds (i.e., bonds that exhibit a non-negligible default risk) more complicated. The variation of a default-able bond price can be viewed as two layers of variation: the variation in the default-free bond prices, and the variation in the adjustment the market makes for default. Using the government bonds as a benchmark allows us to separate these two layers and to gain a better understanding of how bond investments work (as we can compare the two bond prices, as done in the previous section).
A corporate bond price can change because the prices of all bonds change (i.e., market interest rates change — this is the first layer mentioned above), or because the market view of the default risk of this particular bond changes (the second layer). This second layer relies on perceptions —
the market adjusts prices to account for new information as they collectively perceive it. Suppose, for example, the release of a company’s financial statements causes its bond prices to drop — the bond markets have updated their perception of the company’s ability to repay their debt. You
might agree with the market that the financial statements do contain negative information, but perhaps you think that the drop was too significant relative to how bad the new information was. Therefore, you agree the bonds should now be worth less, but not quite as little as the market has decided. Seeing this over-correction (or undervaluation) you probably would want to purchase these bonds since the bonds are cheap relative to your view, and this cheapness is probably enough to induce you to bear the risk of default (which you view differently to the market).
Recall that the way the market updates prices as new information is revealed is known as the efficiency of the market. This does not necessarily assume that the Efficient Markets Hypothesis (which we dealt with in Module 1) is true. The Efficient Markets Hypothesis is a very specific and formal statement about how efficient markets are. Whether this hypothesis truly holds, or which precise version of the hypothesis holds, is an open academic matter, but it is definitely true that
markets are usually very efficient. In the normal course of events, modern financial markets do in fact incorporate new information (whether formal financial news or informal speculation about prospects for the future) very rapidly, as investors compete to adjust to any new information
about potential investments. In our previous example of an investor — who thinks the market reaction to the financial statements was too severe — buying the cheap bond is market efficiency in action.
Accordingly, the increased demand will pressure the bond price to increase, and it is the aggregation of all competing investor’s actions that result in efficient, continually-updating market prices. We have discussed how bonds exhibit market risk (their prices can change before maturity), and, if the issuer is liable to default, credit risk.