Credit Spreads

[wmalik]

Hi

Could you give me examples of what can lead to any changes in credit spreads? (Credit spreads was mentioned in Exam B and I just want to understand it better)

Thanks

 

[waqas ahmed]

Hi

Could you give me examples of what can lead to any changes in credit spreads? (Credit spreads was mentioned in Exam B and I just want to understand it better)

Thanks

I think credit spreads consist of
Default
Downgrade
Matching Adjustment ( liquidity premium)
Anything which will impact any of the above components will change the overall spread.
if the probability of default changes this will widen the credit spread. So your total yield will increase and will reduce the MV of the Asssets. there can also be impacts on liabilities if it's a MA portfolio.

Let the tutor confirm this but that's how I understood.

 

[Lindsay Smitherman]

Credit spread is basically defined as the excess of yield obtained on a non-risk-free bond relative to the risk-free yield.

As mentioned above, it includes compensation for illiquidity, expected default and uncertainty relating to possible default or downgrade events. Therefore as indicated in the previous post, anything which impacts these aspects could result in changes to credit spreads. This could be across bonds generally (e.g. a general economic downturn) or in relation to specific bond issues (fears of a specific corporate failure).

If a credit spread widens then, as the previous poster states, the market value of such assets will fall. If the widening was due to an increase in the illiquidity premium component of the credit spread, then the value of liabilities could only be reduced if you had a matching or volatility adjustment approved and in place.

Hope that helps.

 

[mhung.le]

Hi Lindsay,

When the question asked: "outline possible causes of the widening of corporate bond credit spread". I am wondering how much in details I need to provide? and wonder if my answers below would be valid?

- The counterparty was downgraded. For example, the issuer of corporate bonds was downgraded from AA- to A.
- The bond issuer is facing with liquidity issue which could cause the spread widening.
- Maybe due to the recent economic downturn that increase the volatility of a particular sector (eg. banking sector), thus increase the probability of default.

Thanks.

 

[Lindsay Smitherman]

Hi - yes, these points are valid possible causes of the widening of a corporate bond credit spread.

In terms of how much detail you would need to include in an answer, this would depend on how many marks there are available and the command verb used.

 

[mhung.le]

Thanks Lindsay.

 

[ac1003]

Hi - I’m trying to understand credit spreads in the context of how they widened at the start of Covid-19 please.

I’m looking at a graph of corporate bond yields and government bond yields from that time. It looks like government bond yields fell (ie higher price, presumably due to higher demand as safer assets) and corporate bond yields increased (ie lower price, less demand due to higher risk of default). Thus the spread widened. Is this right? Are there any arguments I’m missing here, eg in terms of liquidity?

Also, am I right to think that credit spreads can therefore change just with government bond yields changing alone (if corporate bond yields remained the same), so there’s 2 angles to think about and not just the yield on corporate bonds?

Thanks

 

[Lindsay Smitherman]

If government bond yields fell, you would expect corporate bond yields to fall as well - all else being equal.

If they haven't done so then yes, that would imply that the spread on corporates has increased - so for whatever reason the market must think that there is now higher liquidity and/or default risk on such bonds.

The start of the pandemic would be a good example of that, with the market being worried that companies would struggle more with paying coupons and making scheduled bond repayments, given the significant impact on normal business activity for so many industries.