The Term Structure of Credit Spreads
Illustrations usually help prove a point or, in the case of analysis, help analysts envision risks graphically. Just think about a graphed yield curve, which shows the yields of bonds over various maturities.
Likewise, analysts can also develop and study graphs that indicate the credit risk associated with various bonds over time. What might this graph be called?
And while there are many uses for credit spreads, there are also several key factors that determine the structure. For example, think about how _credit quality_ would impact the credit spread. If a bond is investment grade with the highest ratings, credit spread migration is only possible in one direction because the bond still carries slight risk above the risk-free rate. So what would you expect the credit structure to look like for this bond?
Not quite.
The default curve doesn't capture all of the credit risk.
No way.
The liquidity curve would show the bond's trading liquidity, not trading risk.
Incorrect.
The bond is the safest option above the risk-free rate.
Nice try, but no.
A gradual upward-sloping curve indicates that there's growing credit risk over time, but this bond is highly rated.
Then there's the impact of _financial conditions_. At the macro level, credit spreads are impacted by expectations for economic growth and inflation. At higher growth levels, benchmark yields tend to be higher, but credit spreads actually tend to be lower. How would you describe the relationship between credit spreads and economic growth?
No.
Credit spreads don't cycle with the economy. That would indicate a direct relationship.
Definitely not.
A highly positive correlation means that credit spreads and the economy are completely in sync, which isn't the case at all.
That's it!
When the economy is booming, yields tend to be higher while spreads are narrower, which indicates an inverse relationship. That makes the business cycle an important data point for bond analysts.
Analysts should also factor in _market supply_ and _demand dynamics_ as well as a bond's liquidity. For most bonds that have been issued, there's minimal trading during the day, meaning that the credit spread is highly impacted by new issues, which trade more frequently. Likewise, illiquid bonds usually have wider bid-ask spreads that can also impact the shape of the credit structure.
In addition to trading and liquidity data, credit structures are also influenced by microeconomic variables such as a company's key financial ratios, cash flows, and leverage, versus the sector and peers. This data can then be paired with structural models to derive a probability of default. These are _company-value model results_.
For example, many analysts will study equity volatility as one microeconomic factor to include in the model. Suppose a company has a significantly volatile stock. All else equal, how do you think that impacts the credit structure's slope?
Yes, it does.
If the company's equity volatility is high, then that indicates higher risk, which is going to factor into the pricing of the company's bonds by increasing the company's spread. So the company will have a steeper credit spread, given its equity volatility.
Together, credit quality, financial conditions, market supply and demand dynamics, and company-value models are all factors that influence the credit spread. Yet the construction of the credit spread also matters in analysis.
For example, since credit spreads are measured against a benchmark rate, a key consideration in analyzing credit spreads is considering what rate is used as the benchmark rate. Ideally, a frequently traded government security with the nearest maturity to an outstanding corporate bond typically captures the lowest default risk. But many times, this on-the-run government bond doesn't accurately align with the corporate bond. Why would an on-the-run government bond not align with a secondary corporate bond?
No way.
The spread is the difference between yields, so the interest rates don't need to match.
No.
The principal values don't impact the calculation between yields.
Exactly.
A corporate bond trading in the secondary market typically won't have the same maturity and duration as an on-the-run government bond. This makes the choice of a benchmark more difficult. Plus, for less-liquid securities, interpolation isn't the best choice, so many times analysts will substitute the benchmark swap curve based on interbank rates because it has greater liquidity.
The other consideration is to ensure that bonds included in the term structure analysis are similar. For example, any bond with embedded options, first or second lien provisions, or other unique characteristics should be excluded.
Once analysts have considered these factors and considerations, the real analysis can begin. As you can probably guess, a flat credit spread indicates a relatively stable expectation of default over time, while an upward sloping credit curve implies that investors demand more compensation for taking on greater default risk. And this general knowledge can help you understand the typical shapes of credit curves.
For example, take a high-quality issuer with strong cash flow, low leverage, and high profit margins. Clearly, this is a high-grade issuer, but these strong company-specific characteristics are usually captured at the short end of the credit curve with low short-term spreads. Why might the long end of the credit curve reflect higher spreads?
Conversely, high-yield issuers in cyclical industries sometimes face downward-sloping credit curves. For example, a leveraged buyout may cause short-term credit risk concerns that are expected to weaken over time. Or, for companies with large capital projects that take time, the credit spread can also be downward sloping when the economy is at the bottom of the cycle. Why would the company's credit spread be downward sloping at the bottom of an economic cycle?
That's not it.
That's a short-term measure that would be reflected in the short end of the credit curve.
No way.
That's a short-term concern that would be reflected in the short end of the credit curve.
No.
Equity volatility is a measure of risk, just like credit spreads.
Definitely not.
Equity volatility impacts the data input into credit spread models.
No.
In the short-term, the company is investing in its capital projects, which places stress on cash flows. That makes the credit spread higher in the short term.
No way.
As the economy bottoms out, the company should experience higher growth potential.
However, it's important to note that some companies don't make it to the economic recovery phase and instead reach bankruptcy. For many companies and investors, this becomes an inevitability, which makes the bond stop trading based upon credit spreads and start trading more in line with what investors anticipate receiving. What's the trading focus for a bond near default?
Not quite.
Even though the bond is going to default, it could still potentially return money to investors.
Incorrect.
The bond is going to default, meaning that it's not going to pay par.
Right you are!
The defaulting bond is going to trade according to its recovery rate, not according to its credit spread. So this can lead to a situation where the credit spread doesn't actually capture the true value of the bond. For some investors, this situation actually presents an opportunity.
For example, for a bond facing a high probability of short-term default that declines over time, a contrarian portfolio manager might decide to sell short-term protection to collect a premium and buy long-term protection. If the bond makes it past its predicted default, the manager gets to keep the premium and can potentially sell the long-term protection.
To summarize:
[[summary]]
Yes.
For this investment-grade, highest-quality bond, the credit spread structure will be essentially flat or slightly upward sloping. But bonds with lower credit ratings will have a steeper credit curve because these bonds have a higher sensitivity to the credit cycle.
That's right!
Uncertainty over future technological changes can impact the long end of the credit curve because analysts are uncertain about the company's long-term future prospects. This uncertainty regarding technology, the global economy, competition, or other factors leads the typical credit spread term structure to be upward sloping for investment-grade bonds.
Exactly!
As the economy rebounds, the company's financial strength should improve and its capital investments should start paying off. That makes the credit risk in the future less than the short-term credit risk, so the credit term structure is downward sloping.
That's right!
A credit curve will capture the spread of a benchmark security for an issuer of outstanding fixed-income securities over various time periods. This graphical representation helps issuers, underwriters, and investors measure the risk-return relationship. For example, issuers and underwriters can price new offerings off of the credit spread, and investors can use the credit spread to evaluate potential bids. Even government officials can use the credit spread to understand fiscal and monetary policy impacts on the bond market.
Credit curve
Default curve
Liquidity curve
High upward sloping
Gradual upward sloping
Either flat or slight upward sloping
Inverse
Cyclical
Highly and positively correlative
It increases the slope
It decreases the slope
There's no impact
The interest rates don't match
The principal values don't match
The duration and maturity don't match
Uncertainty about future technological changes
Uncertainty surrounding the one-year EPS forecast
Uncertainty over current restructuring charges impacting net income
The company's short-term prospects are strong due to the economic rebound
The company's long-term projects are uncertain due to the economic slowdown
The company's future economic outlook is positive due to the economic rebound
Zero
The par value
The recovery rate
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