Credit Spread
What you'll learn
- LOS 26.fInterpret changes in a credit spread.
- LOS 26.gExplain the determinants of the term structure of credit spreads and interpret a term structure of credit spreads.
A benchmark yield should be equal to the real risk free rate plus expected inflation, as well as a risk premium for uncertainty in future inflation. Credit spreads include compensation for default, liquidity, and taxation risks relative to the benchmark. Adjustment to the price for all these risk factors together is known as the XVA.
In this reading, we focus only on the default risk component (i.e., CVA) as it is the most important and most commonly used in practice.
Credit spreads change as investor perceptions about the future probability of default and recovery rates change. These perceptions depend on expectations about the state of the economy. Expectations of impending recessions lead to expectations of higher defaults and lower recovery rates.
Joan De Silva, a junior analyst, works for a regional bank. Currently, De Silva is evaluating a 3 year, annual pay, 3% XYZ corporate bond priced at $102. The benchmark yield curve is flat at 1.75%.
De Silva prepares Table 1 assuming a hazard rate of 1.25% and a recovery rate of 70%.
Table 1: Credit Analysis of 3%, 3 Year Bond With 1.25% PD and 70% RR
Exposure is the amount of money a bond investor in a credit risky bond stands to lose at a point in time before any recovery is factored in.
The exposure for each period is calculated given the coupon of $3 and risk free rate of 1.75%:
De Silva prepares a report including Table 1 for Susan Collins, Chief Investment Officer. Collins states that based on the expectations of a slowdown in the economy, a 1.50% hazard rate and a recovery rate of 60% would be more appropriate for XYZ.
De Silva updates those estimates and prepares Table 2.
Table 2: Credit Analysis of 3%, 3 Year Bond With 1.50% PD and 60% RR
- Using De Silva’s estimates of hazard rate and recovery rate, XYZ bond is currently most likely:
A. undervalued.
B. overvalued. C.
fairly priced.
- Using the market price of the bond, the credit spread on XYZ bond is closest to: A. 0.44%.
B. 0.49%. C.
0.55%.
- Assuming the market price changes to reflect Collins’s expectations of PD and recovery rate, the new credit spread would be closest to:
A. 0.52%.
B. 0.61%.
C. 0.79%.
Solution
The term structure of credit spreads shows the relationship between credit spreads and maturity. Term structures can be for different bonds issued by the same issuer (with varying maturities) or different bonds within a sector (e.g., AA term structure). Term structures can be useful for investors to price a new issue, as well as to determine the relative valuation of an existing issue.
A credit spread curve displays this relationship graphically. Figure 26.4 shows yields on U.S. Treasury bonds and high quality (AAA) corporate bonds. Figure 26.5 shows the resulting HQM spread curve.
Figure 26.4: U.S. Treasury and High Quality Corporate Bond Yields
Figure 26.5: Credit Spread Curve: High Quality Corporates
The credit spread is inversely related to the recovery rate and positively related to the probability of default. Recall that credit spread is calculated as the difference between the yields of a risky security and a benchmark security with the same maturity. However, oftentimes a maturity matched, liquid (i.e., frequently traded) benchmark security is not available.
In such cases, interpolation from available benchmark securities is used. When such data is not easily available, or when benchmark bonds are thinly traded, a spread relative to a swap fixed rate (corresponding to the maturity of the bond) may be used.
To create a spread curve, all of the bonds whose spreads are used should have similar credit characteristics. Differences in seniority, first/second lien provisions, and embedded options distort the computed credit spread. A spread curve using these distorted spreads would not be an accurate reflection of the term structure.
Key determinants of the shape of the credit spread curve include expectations about future recovery rates and default probabilities. If default probabilities are expected to be higher (or recovery rates lower) in the future, the credit curve would be expected to be positively sloped. Flat credit curves indicate stable expectations over time.
Determinants of Term Structure of Credit Spreads
Determinants of the term structure of credit spreads are as follows:
- Credit quality is an important factor driving term structure; AAA term structures tend to be flat or slightly upward sloping. Lower rated sectors tend to have steeper spread curves, reflecting greater uncertainty as well as greater sensitivity to the business cycle.
- Financial conditions affect the credit spread curve. Spreads narrow during economic expansions and widen during cyclical downturns.
During boom times, benchmark yields tend to be higher while credit spreads tend to be narrower.
- Market demand and supply influence the shape of the spread curve. Recall that a credit spread includes a premium for lack of liquidity.
Hence, less liquid maturities would show higher spreads (even if the expectations for that time period are stable). Due to low liquidity in most corporate issues, the credit curves are most heavily influenced by more heavily traded bonds. Because newly issued bonds are generally more liquid, when an issuer refinances a near dated bond with a longer term bond, the spread may appear to narrow for the longer maturity (possibly leading to an inverted credit spread curve).
- Equity market volatility: Company value models (structural models discussed earlier) employ a company’s stock price volatility and balance sheet structure in determining the probability of default. Increases in equity volatility therefore tend to widen spreads and influence the shape of the credit spread curve.