Topic 4 - Bonds ((iv) Credit spread (quality spread) and its components)

Question 1

Credit Spread and components

Answer 1

• Credit risk is an additional source of risk for corporate bonds.
• The yield required by the market on a corporate issue is a function of the default risk of the bond: The greater the risk, the higher the yield the borrower must pay.
• This implies that the yield reflects a credit spread, or quality spread, over the default-free yield.

• The credit spread captures three components:

1. An expected loss component (default risk)
2. A credit-risk premium (credit risk)
3. A liquidity premium (liquidity risk)

• International rating agencies (Moody’s, Standard & Poor’s, Fitch) provide a credit rating indicating the level of these risks for most of the debt issues traded worldwide.

Question 2

Credit Spread (An expected loss component)

Answer 2

• Investors expect that the bond will default with some probability.
• To compensate for that expected loss, the issuer must pay a spread above the default-free yield.
• If investors were risk-neutral, they would require only that the expected return on the corporate bond, taking into account the probability of default, be equal to the default-free yield

Question 3

Credit Spread (A credit-risk premium (credit risk))

Answer 3

• Investors are risk-averse and cannot easily diversify the risk of default on bonds.
• Furthermore, when the economy is in recession, the financial situation of most corporations deteriorates simultaneously.
• This is, Investing in part, systematic market risk (business cycle risk) as the stock market is also affected.
• So, investors require a risk premium to compensate for that risk, on top of the expected loss component.

Question 4

Credit Spread (A liquidity premium (liquidity risk))

Answer 4

• Each corporate bond is a bit different from another one, in part because each issuer has some distinctions in quality from other issuers.
• All domestic government bonds have the same credit quality within their domestic market (e.g., U.S. Treasury in the United States, British gilts in the United Kingdom, or JGB in Japan); there is a vast amount issued and excellent trading liquidity.
• Because of the lack of liquidity on most corporate issues, investors require a compensation in the form of an additional yield, a liquidity premium.
• In practice, it is difficult to disentangle the liquidity premium and the credit-risk premium.