Contingency Provisions
Contingency provisions allow for some conditional actions. They grant the issuer and/or the... Read More
As we saw previously, the yield on a government bond (the benchmark) is:
$$\text{Goverment bond yield = Real risk-free interest rate + Expected inflation rate + Maturity premium}$$
To this benchmark yield, we need to add the yield spread, the spread above which a corporate bond might trade:
$$\text{Yield on a corporate bond = Government bond yield + Liquidity premium + Credit spread}$$
Credit risk is the probability of default and the recovery of assets in case of default. On the other hand, liquidity risk is the potential risk of an investor failing to sell their bond at an acceptable price—often because of the bid-ask spread in thinly traded bonds.
Yield spreads on all corporate bonds can be affected by several factors, including:
Question
If investors are increasingly optimistic about the economy, what is the most likely impact of their optimism on credit spreads?
- Narrower spreads will occur. Investors are less concerned about creditworthiness.
- Wider spreads will occur. Investors will move out of equity markets into debt markets.
- There will be no change to credit spreads. Equity markets work independently from fixed-income markets.
Solution
The correct answer is A.
In a booming economy, investors will require smaller yield spreads to compensate for credit risk. Conversely, credit spreads widen during weak financial markets.