Factors that Influence the Level and Volatility of Yield Spreads

As seen previously, the yield on 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, which is the spread above which a corporate bond might trade:

$$\text{Yield on a corporate bond = Goverment bond yield + Liquidity premium + Credit spread}$$

Where the credit risk is the probability of default and the recovery of assets in case of default, and the liquidity risk is basically the risk that the investor might not be able to sell its 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 a number of factors including:

  • Credit cycle: As the credit cycle (expansion and contraction of access to credit over time) improves, the credit spread narrows.
  • Broader economic conditions: Weakening economic conditions will push investors to demand a greater risk premium and a wider credit spread.
  • Financial market performance: In times of crisis, such as during the 2007-2009 Global Financial Crisis, credits spreads widen.
  • Broker’s-dealer’s willingness: to provide sufficient capital for market-making.
  • 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.

Question

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

A. There will be no change to credit spreads. Equity markets work independently from fixed-income markets.

B. Narrower spreads will occur. Investors are less concerned about creditworthiness.

C. Wider spreads will occur. Investors will move out of equity markets into debt markets.

Solution

The correct answer is B.

In a booming economy, investors will require much lesser yield spreads to compensate for credit risk.

Reading 47 LOS 47i:

Describe factors that influence the level and volatility of yield spreads

Share:


Related Posts

Basic Features of a Fixed-income Security

A fixed-income security is a financial obligation that pays a fixed amount of interest—in the...

Legal, Regulatory, and Tax Considerations of Fixed-income Securities

Fixed income securities are dependent on laws and regulations of the place of...