What the Deepwater Horizon disaster tells us about bond pricing

It should come as no surprise that the recent events in the Gulf of Mexico have caused the market value of BP's shares to plummet: on April 19, 2010, the day before the accident, BP's share price was $59.48, and on June 16 it had fallen to $29.92. What has happened over the same period to the market value of BP's debt? A look at this is instructive on the relationship between the market price of fixed-rate debt and its yield.

In August 2009, BP Capital Markets LLC issued $750 million of two-year notes guaranteed by its British parent company, BP plc. The stated interest rate (coupon) on the notes was 1.55%, which was 50 basis points (.05%; a basis point is 1/100th of 1%) over the interest rate at that time on two-year Treasury notes. (The stated interest rate on corporate debt securities is often expressed as a percentage over the Treasury security with a corresponding maturity (the credit spread), with the credit spread being greater for issuers that are considered to be more risky.)

Before the Deepwater Horizon disaster, these BP notes were being traded at close to par - in other words, an investor who wanted to acquire one of these outstanding notes with a principal amount of $1,000 (the face amount) would have to pay about $1,000 for it. But that was soon to change for the worse: according to an article on Barron's online on June 19, the trading price for a BP note with a $1,000 face amount on June 16 was $891.80. This makes intuitive sense: on June 16 the marketplace was swirling with rumors about the possibility of a BP bankruptcy. If the total amount of BP's liabilities relating to the oil spill were to increase to the point where BP was insolvent, in a bankruptcy BP's unsecured creditors (including the holders of these notes) would each get less than the face amount of their claims, depending on the extent of the insolvency. So, it is easy to see why a potential purchaser of BP notes on June 16 would only be willing to pay a price less than the face amount (a purchase at a discount), to compensate for BP's increased credit risk.

Assuming BP stays out of bankruptcy and pays these notes off in full at maturity, how much interest will the purchaser who paid $891.80 get? Asked a different way, what is the note's yield to maturity (YTM)? The investor will earn 12.80% on the investment. Why is this? Because, at maturity it will receive a principal payment from BP of $1,000, the full face amount of the note. (Just because a debt security is trading at a discount in the market doesn't mean that the issuer's obligation to pay the full face amount at maturity, together with interest on the face amount at the coupon rate, is affected.) The difference between that $1,000 principal payment at maturity and the $891.80 the investor paid for the note is $108.20, which is treated for economic purposes as if it were interest received on the investment, in addition to the interest that will be paid to the investor by BP at the stated rate of 1.55% on the full $1,000 face amount. As a result, the investor is effectively earning 12.80% on its $891.80 investment.

This highlights a key principle of investment theory: there is an inverse relationship between the market value of a fixed rate debt security and its yield to maturity. As the market price of such a security goes down, its yield goes up, and vice versa. We can look at the example of the BP notes a different way: the only way a prospective purchaser of the BP notes on June 16 could be enticed to invest is if it is compensated for the increased risk attributable to BP's potential liabilities for the oil spill. Investors on that date demanded an interest rate of 12.80%, and in order for that to happen the selling price of the bonds had to be lowered to $891.80.