Changes in Credit Spread and Liquidity on Yield-to-maturity

The yield-to-maturity on a corporate bond is comprised of a government benchmark yield and a spread over that benchmark.

The building-blocks approach implies that the yield-to-maturity changes can be broken down further. The benchmark yield could change because of either a change in expected inflation rate or in expected real interest rate.

A spread change could also arise due to change in credit risk of the issuer or in liquidity of bond.

Assume that a bond with a modified duration of 4.00 and a convexity of 25.00 will appreciate by around 0.81%, regardless of the source of the yield-to-maturity change, if the yield-to-maturity decreases by 20 bps.

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Let’s also assume that the yield to maturity on a corporate bond is 5.75%. If the benchmark yield is 4%, the spread is 1.75%. Credit risk is estimated to be 1.25% of the spread and liquidity risk is the remaining 0.50%. Credit risk is the probability of default and the recovery of assets in case of default.

Liquidity risk is much lesser when there is a greater frequency of trading and higher volumes of trading.

There is a difference between the bid (or purchase) price and the offer (or sale) price. The difference depends on the type of bond, the size of transaction, and some other factors. For instance, government bonds often trade just a few basis points between purchase and sale prices. Thinly traded corporate bonds could have a much wider difference between bid and offer prices.

Question

Fill in the following sentence with an appropriate wording.

__________ risk is much lesser when there is a greater frequency of _________ and higher volumes.

A. Liquidity; trading

B. Bid price; speculation

C. Interest rate; transparent markets

Solution

The correct answer is A.

Liquidity risk is much lesser when there is a greater frequency of trading and higher volumes (of trading).

 

Reading 54 LOS 54l:

Explain how changes in credit spread and liquidity affect yield-to-maturity of a bond and how duration and convexity can be used to estimate the price effect of the changes

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