What drives credit spreads

What is inside a corporate bond yield?

A corporate bond yields more than a government bond of similar maturity. The government yield is the benchmark: a real rate plus a premium for expected inflation. The extra yield on top is the yield spread, and it contains pieces.

Corporate bond yieldbenchmark yield plus yield spread

• Benchmark yield Use it government bond: real rate plus expected inflation
• Yield spread Memorize extra yield over the benchmark
  • Credit spread Memorize pays for expected loss from default
  • Liquidity spread Memorize pays for the cost and difficulty of trading
  • Tax effects Know the idea where the bond is taxed differently

The credit spread pays for the chance of loss from default. The liquidity spread pays for the cost and difficulty of selling the bond. There may also be a small tax effect. When any piece changes, the bond’s yield, price and return change. Credit spread risk is the risk of greater expected loss because credit conditions change, through macroeconomic, market or issuer-related factors.

Why do credit spreads widen and narrow?

There are three families of drivers.

Family	Spreads widen when…	Notes
Macroeconomic	the credit cycle turns down and recession risk rises	Narrowest near the top of the cycle, widest near the bottom. HY reacts more than IG
Market	liquidity dries up, dealers hold less inventory, heavy new supply meets weak demand, investors flee to quality	Flight to quality: government yields fall while credit spreads widen
Issuer-specific	coverage falls, leverage rises, a downgrade or a failed equity raise hits, or the business model is shocked	Compare an issuer with its rating peers to separate issuer news from market moves

What moves credit spreadslevel and volatility

• Macroeconomic Memorize the credit cycle follows the business cycle
  • Narrowest near the top of the cycle Memorize credit risk seems lowest
  • Widest near the bottom Memorize credit risk seems highest
  • High yield moves more Memorize than investment grade
• Market Memorize how easily bonds trade
  • Liquidity and dealer capacity Use it less market-making means wider spreads
  • Supply and demand Use it heavy new issuance with weak demand widens
  • Flight to quality Memorize sell risky bonds, buy government bonds
  • Funding stress Use it wider spreads
• Issuer-specific Memorize the company or government itself
  • Coverage and leverage Use it weaker coverage and higher leverage widen
  • Events Use it a downgrade, failed share sale, shock to the business model
  • Compare with peers Use it same rating or sector isolates issuer news from market moves

The credit cycle. The credit cycle moves with the business cycle. As the economy improves, investors accept more credit risk and spreads narrow. When it weakens, spreads widen. Spreads are narrowest at or near the top of the cycle, when credit risk looks lowest, and widest at or near the bottom, when it looks highest. High-yield spreads move much more than investment-grade spreads, because high-yield bonds are more sensitive to economic and credit conditions.

Three more patterns are useful. Higher-rated bonds yield less at any maturity. Longer-maturity bonds usually yield more, because default risk grows with time. The gap between neighboring investment-grade ratings is smaller than the gap between investment grade and high yield.

Market factors. In a flight to quality , investors sell risky assets and buy default-risk-free government bonds. Government yields fall while credit spreads widen, and high yield suffers most. Other market factors:

• Corporate bonds trade mainly over the counter through dealers who use their own capital. Tighter bank capital rules make holding credit bonds costlier, so dealers make markets less eagerly, particularly in stress.
• Funding stress widens spreads. Heavy new supply widens them if demand is weak, and strong demand tightens them.
• Stress in one segment can spill over. Fear among high-yield investors can widen spreads even on the lowest investment-grade ratings.

Issuer-specific factors. Debt coverage (cash flow compared with the payments due) and leverage (reliance on debt) matter for every issuer. Investors often judge an issuer’s yield against bonds of the same rating, the same sector or a similar business model. If the issuer’s yield moves far more than its peers’, the news is about the issuer, not the market.

Exam tip Cycle questions test one fact: spreads are widest near the bottom and narrowest near the top. High yield moves more than investment grade at every stage.

Go deeper Spread curves over the cycle

Plot the spread against maturity and the curve changes shape through the cycle. In expansions investment-grade curves are low and gently upward sloping, and high-yield curves are higher and steeper. Near the bottom of the cycle, high-yield curves widen sharply and can invert, because investors fear defaults in the near term more than later. In a recovery the short end tightens first and the curve steepens again.

Why do investors hold high yield anyway?

High-yield bonds offer larger coupons for greater risk, but investors have three more reasons.

Reasons to hold high-yield bondsbeyond the higher coupon

• Diversification Memorize lower correlation with investment-grade and government bonds
• Capital appreciation Memorize recoveries, upgrades, mergers and better management lift prices more than for IG
• Equity-like return, lower volatility Memorize the large income component steadies returns

Economic recovery or better issuer performance usually lifts high-yield prices more than investment-grade prices. Rating upgrades, mergers and better management also help. High-yield bonds and shares tend to move together over the cycle, but the large income component makes high-yield returns steadier. Against that, high yield is exposed to market liquidity risk when volatility rises and cash is needed.

What is the liquidity part of a spread?

Market liquidity risk is the risk that the price at which you can actually trade differs from the price you see. It shows up in the bid–offer spread : dealers buy at the bid, which is lower, and sell at the offer, which is higher. The most liquid government bonds trade within a fraction of a basis point. Less liquid corporate bonds can have a much wider gap. Liquidity risk is higher when:

• the issuer has little debt outstanding;
• the bond trades rarely; and
• the issuer’s credit quality is lower.

In a crisis liquidity can disappear, prices fall and spreads widen sharply.

The liquidity spread turns the bid–offer gap into yield terms. A lower bid price means a higher bid yield, so subtracting the offer yield gives a positive number.

$$\text{liquidity spread} = y_{bid} - y_{offer}$$

For a zero-coupon bond, each yield comes straight from the price.

$$y = \left(\frac{100}{P}\right)^{1/N} - 1$$

Subtract the liquidity spread from the total to isolate the credit part.

$$\text{credit spread} \approx \text{yield spread} - \text{liquidity spread}$$

Go deeper Why capital rules can widen spreads in stress

Dealers must hold capital against the bonds they own. When rules make that capital more expensive, dealers carry less inventory and quote wider bid–offer gaps, and liquidity thins out just when sellers need it. That is one reason liquidity spreads jump in a crisis.