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Level and volatility of yield spread

In general, lower the credit quality and hence higher the credit risk, the higher will be quoted yield. Even though the realized yield is different from the quoted yield due to losses, it is still high when credit risk is high.

The safest bonds (such as government bonds in the US, Germany) have no default risk, hence their yield is composed of real interest rate, expected inflation and maturity premium.

\[ Yield\ on\ government\ bonds = R_r + I_e + MP \]

Where Rr is the real interest rate, Ie is the expected inflation and MP is the maturity premium.

Corporate bond yields exceed government bond yields and the difference is called yield spread, which is the sum of liquidity premium and credit spread.

\[ Yield\ spread = Y_C – Y_G \]

Where YC is the yield on corporate bonds, and YG is the yield on government bonds.

\[ Yield\ spread = Liquidity\ premium + Credit\ spread \]

In practice, only the yield spread is observable, but the components are not separately identifiable.

Factors affecting yield spreads

Yield spreads on corporate bonds are affected by the following factors, with lower-quality issuer experience more spread volatility:

  • Credit cycle: The credit cycle is the expansion and contraction of access to credit over time. Spreads are lowest when the credit cycle improves, and they widen if the credit cycle deteriorates.
  • Broader economic conditions: Weakening economic conditions widen spreads and vice versa.
  • Financial market performance: Spreads are low in strong markets or markets where volatility is low, and high when financial markets (including equity markets) are not doing well.
  • Broker-dealer willingness to provide capital for market-making: In times of financial crises, capital provided by broker-dealers dries up sending yield spreads soaring.
  • General market supply and demand: Where new issues are high, spreads will widen if demand is insufficient, and if demand is high and supply is low, spreads tighten.

Spread risk

Since the default risk for investment-grade bonds is very low, investors are more concerned about spread risk, the risk of loss from changes in spread. The price impact of spread change depends on (modified) duration and magnitude of spread change.

\[ Price\ impact = − Modified\ Duration × ∆Spread \]

The negative sign shows a negative relationship between spread and bond price, i.e. low spread means high bond price. For large spread changes, a fuller breakdown of impact is given by a combination of duration and convexity.

Spread/credit curves

Bonds with higher duration are more sensitive to changes in spread. Bonds with longer maturity have higher yields because while the probability of default may be low in the near future, in very long-term, it might be very difficult to confidently determine default probability many years into future. Further, since bid-ask spread results in higher transaction costs for longer-duration bonds, the spreads are higher too, as evident from upward sloping spread curves (also called credit curves).

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