Credit Quality

Credit spreads vary across industrial sectors. When credit spreads are narrowing relative to government bonds, the spreads between higher- and lower-rated corporate bond categories also narrow.

During these times, although corporate bonds generally outperform government bonds, lower-rated corporate bonds tend to outperform higher-rated bonds. The converse is true as spreads widen.

The types of goods and services produced by different companies influence credit spreads. The credit spreads of cyclical companies are more sensitive to fluctuations in economic factors relative to those of non-cyclical companies.

Although the business cycle drives corporate bonds’ credit spread, the issuers’ rating and credit sector dictate the impact of the economic environment on spreads. Profitable issuers have low debt interest payments. Besides, issuers who do not rely heavily on debt financing have a high credit rating because of their high ability to repay.

Question

When credit spreads are narrowing relative to government bonds, the spreads between higher and lower-rated corporate bond categories also narrow. Which of the following expectations is most likely true during these times?

1. Government bonds generally outperform corporate bonds.
2. Higher-rated corporate bonds outperform lower-rated corporate bonds.
3. Lower-rated corporate bonds tend to outperform higher-rated bonds.

Solution

The correct answer is C.

Credit spreads vary across industrial sectors. When credit spreads are narrowing relative to government bonds, the spreads between higher- and lower-rated corporate bond categories also narrow. This is because investors are less discerning between weak and strong credit, and the rate of improvement is more significant for those bonds issued by entities with a relatively weaker ability to pay.

In these times, although corporate bonds will generally outperform government bonds, lower-rated corporate bonds will tend to outperform higher-rated bonds. The converse is true as spreads widen.

Reading 43: Economics and Investment Markets

LOS 43 (g) Explain how the characteristics of the markets for a company’s products affect the company’s credit quality.