Understanding Credit Yields and Spreads | CFA Level I Fixed Income

Today, we’ll learn about credit yields and spreads, particularly for corporate debt.

Credit Yields and Spreads

Recall that bonds with credit risk trade at higher yields than risk-free bonds. The difference in yield between a credit-risky bond and a credit-risk-free bond of similar maturity is called its yield spread.

The size of the spread reflects the creditworthiness of the issuer and the liquidity of the market for its bonds. A decrease in creditworthiness or a decrease in liquidity will result in an increase in spread.

Factors Affecting Yield Spreads

Spreads on corporate bonds can be affected by several factors, with lower-quality issuers typically experiencing greater spread volatility. Some key factors include:

• The credit cycle: As the credit cycle improves, credit spreads will narrow. They are tightest at or near the top of the credit cycle. Conversely, a deteriorating credit cycle will cause credit spreads to widen.
• Economic conditions: A strengthening economy will cause credit spreads to narrow, while weakening economic conditions will push investors to desire a greater risk premium and drive overall credit spreads wider.
• Financial market performance: In strong markets, credit spreads tend to narrow. Spreads will also typically narrow in a steady, low-volatility environment. In weak financial markets, credit spreads tend to widen.
• Broker-dealer capital: When broker-dealers provide sufficient capital, yield spreads are narrower. When market-making capital becomes scarce, the yield spreads can widen. For example, during the 2008 global financial crisis, several large broker-dealers either failed or were taken over, reducing the total capital available for making markets and causing yield spreads to increase significantly.
• Market demand versus supply: When demand is higher than supply, spreads can narrow. Conversely, spreads widen when supply outstrips demand. This can happen during periods of heavy new issue supply, causing spreads to widen as there is not enough demand to absorb all the new issues.

In summary, these five factors affect yield spreads for corporate bonds, but they do not affect all corporate bonds equally. Yield spreads on lower-quality issues tend to be more volatile than spreads on higher-quality issues.

Yield Spread Behavior Across the Credit Cycle

Not all corporate bonds are affected equally by economic and market factors. High-yield bonds exhibit larger and more volatile spreads compared to investment-grade bonds, especially during market crises. Furthermore, liquidity plays a crucial role in spread volatility, with high-yield bonds experiencing greater bid-ask spread fluctuations.

Term Structure of Yield Spreads

Yield spreads typically increase with maturity due to the rising probability of default over time. However, economic cycles can significantly affect short-term spreads more acutely than long-term spreads, leading to dynamic changes in the spread curve across different market conditions.

The Benefits of High-Yield Bonds

Despite their risks, high-yield bonds offer several advantages:

• Portfolio Diversification: Their prices often have low or negative correlation with investment-grade bonds.
• Price Gains: Larger spread changes can result in significant price gains during economic recoveries.
• Comparable Returns to Equity: High-yield bonds have historically offered returns close to equities but with lower volatility.

Calculating Bond Price Changes Based on Spread Changes

EXAMPLE: Given a change in spread of a bond, what is the corresponding change in the price of the bond?

Change in the price of a bond = -modified duration x change in yield of the bond.
Since the yield spread is a component of the yield of the bond, we can express this as:

-Modified Duration × Change in Spread

This relationship is only accurate for small changes in spread. For larger changes in spreads, we should add in a convexity adjustment to account for the curvature of the price-spread relationship. Refer back to the lesson on approximate modified duration and convexity adjustments for more details on how to make these calculations.

And that’s a wrap! We’ve covered credit yields and spreads for corporate debt in this lesson.