As seen previously, the yield on government bond (the benchmark) is:
$$Goverment \quad bond \quad yield = Real \quad risk-free \quad interest rate + \quad Expected \quad inflation \quad rate + Maturity \quad premium$$
To this benchmark yield, we need to add the yield spread, which is the spread above which a corporate bond might trade:
$$Yield \quad on \quad a \quad corporate \quad bond = Goverment \quad bond \quad yield + Liquidity \quad premium + Credit \quad spread$$
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.
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.
The correct answer is B.
In a booming economy, investors will require much lesser yield spreads to compensate for credit risk.
Reading 55 LOS 55i:
Describe factors that influence the level and volatility of yield spreads