Factors That Influence the Level and Volatility of Yield Spreads

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:

• Credit cycle: As the credit cycle (expansion and contraction of access to credit over time) improves, the credit spread will be narrow. On the other hand, a weakening credit cycle will widen the credit spreads.
• Broader economic conditions: Weakening economic conditions will make the investors demand a greater risk premium and hence a wider credit spread. On the opposite side, good economic conditions will tighten the credit spread because investors expect an improvement of credit measures which lowers default risk.
• Availability of funding in the financial sector: Since bonds primarily trade over the counter, investors require broker-dealers ‘ willingness to provide sufficient capital for market-making. When there is financial and regulatory stress, it may cause a reduction in capital available for market-making and willingness to buy or sell bonds with credit risk. Low funding availability will cause wider spreads.
• Financial performance of the issuer: corporate bond spreads are affected by the issuer’s development news, such as good earnings news. Such affects the investor’s view on its ability to service and repay debt. Favorable news increases the demand for the issuer’s bonds, narrowing the credit spread. Bad news intuitively widens the credit spread.
• General market supply and demand: in periods of heavy new issue supply, credit spreads widen if there is insufficient demand for these new corporate bonds. When there is a high demand for bonds, credit spreads narrow.

Question

If investors are increasingly optimistic about the economy, what is the most likely impact of their optimism on credit spreads?

1. Narrower spreads will occur. Investors are less concerned about creditworthiness.
2. Wider spreads will occur. Investors will move out of equity markets into debt markets.
3. 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.