Factors Influencing Yield Spreads and Volatility

Corporate bonds and other debt with higher credit risk typically have higher yields compared to default-free bonds like US Treasuries. These yield differences, measured in basis points, can widen due to factors such as declining creditworthiness (credit migration or downgrade risk) or market-related issues like increased risk aversion during financial distress. Credit spread risk refers to the potential for greater expected losses due to changes in credit conditions influenced by macroeconomic, market, and issuer-specific factors.

Macroeconomic Factors

Economic conditions and credit cycles are closely tied. When the economy thrives, credit spreads (the interest rate differences based on credit quality) shrink, indicating investors are okay with more risk. Conversely, in a downturn, spreads widen.

High-yield (HY) bonds, which are riskier, offer several benefits:

1. Portfolio Diversification: HY bonds have a lower correlation relative to investment-grade (IG) and government bonds. So, adding them to a portfolio can provide more variety and potentially better returns for the risk taken.
2. Capital Appreciation: When the economy gets better, or a company issuing the bond performs well, the price of HY bonds can rise more than IG bonds. This can be due to better financial performance, mergers, or positive changes in company management.
3. Stable Returns: Even though HY bond prices move similarly to stock prices, they usually provide steadier returns. This is because they have a bigger interest component. Some studies even suggest HY bonds can give better returns than stocks over a long period, especially for those who do not like the volatility of stocks.

Bonds with higher credit ratings exhibit lower yields for given maturities due to their perceived higher level of security. Conversely, bonds with longer durations typically offer higher yields as a result of increased default risks. The difference in yields between (IG) bonds is comparatively narrower when compared to the difference between IG and HY bonds. During periods of economic volatility, HY bonds are prone to changes in spreads, particularly when investors place greater emphasis on safer assets, a phenomenon commonly referred to as “flight to quality.” Moreover, HY bonds may encounter selling difficulties during periods of economic downturn.

Market Factors

Highly liquid bonds, e.g., sovereign debt from developed countries, have yields that combine real interest rates and an expected inflation premium. On the other hand, corporate bond yields add extra premiums for credit and liquidity risks, as well as potential tax consequences. Market liquidity risk pertains to the costs and uncertainties associated with trading bonds, especially concerning the differences between stated and actual transaction prices. Two key factors tied to issuers, namely the amount of their publicly traded debt and their creditworthiness, influence this liquidity risk. Bonds that trade frequently and in large volumes have reduced liquidity risks. During financial crises, market liquidity can decrease significantly, affecting bond prices and yield spreads across various debt types.

Issuer-specific Factors

Issuer-specific factors are those unique to an individual bond issuer, impacting how their bonds are priced and how volatile those prices might be. Debt coverage and leverage are factors common to all issuers. Debt coverage indicates how easily a borrower can cover its debt obligations using its cash flows. A high debt coverage ratio suggests the issuer has a strong financial position, reducing the risk for bondholders. On the other hand, leverage represents how much debt a company has in relation to its equity or other financing sources. A high leverage can indicate higher risk, as the issuer is more dependent on debt financing.

Repayment and Investment Dynamics

Corporate issuers borrow money to invest in long-term assets that drive profits, like machinery or new facilities. They repay debt from the money they make in their operations. On the other hand, sovereign entities borrow to finance public services and infrastructure. They repay from revenues mainly collected from taxes.

Investor Evaluation Techniques

When assessing the yield and yield spread of a specific issuer’s bond, investors can use the following comparisons:

• Credit Rating: Bonds with the same rating have similar default risks.
• Sector: Companies in the same industry often face similar risks and opportunities.
• Business Model or Features: For example, tech companies might be compared together even if they offer different products.

Question

What is most likely to happen to credit spreads during economic downturns?

1. Credit spreads will remain constant.
2. Credit spreads will narrow.
3. Credit spreads will widen.

The correct answer is C.

During economic downturns, investors become more risk-averse, leading to widening credit spreads as the perceived risk of corporate bonds increases relative to default-free bonds.

A is incorrect: Economic downturns typically do impact credit spreads.

B is incorrect: Credit spreads are more likely to narrow during economic upturns, not downturns.