9-8-2014

Credit spreads: A fixed income investor's must-know guide Market Realist

Credit
spreads: A fixed income investor's must-know guide

Credit spreads: A fixed income investor's must-know guide (Part 1 of 6)

Credit spreads: A fixed income investors must-know guide

By Surbhi Jain - Disclosure Mar 24, 2014 3:56 pm EDT

Credit spreads
Credit spreads are the difference in yield between U.S. Treasuries and corporate bonds of the same maturity. Corporate bonds yield more than
Treasury bonds, as they carry a risk of default. The difference in yields between a corporate bond and a Treasury of the same maturity is actually the
premium that investors require for undertaking the additional credit risk associated with the corporate bond.

U.S. Treasury bonds are considered the safest, as theyre issued and guaranteed by the government of United States.
Calculating credit spreads
The credit spread between a ten-year corporate bond yielding 5% and the ten-year Treasury bond yielding 2% would be 3%.
The current bond yield for a five-year Exxon Mobil (XOM) bond is 1.82%. The corresponding five-year Treasury bond yield stands at 1.73%. So the
credit spread for the Exxon Mobil bond would be 0.09%, or 9 basis points.
At the same time, a five-year JP Morgan Chase (JPM) bond yields 6.3%. Here, the credit spread is much wider, at 4.57% or 457 basis points, than
Exxon Mobils, where the spread is tighter or narrower. This shows that the JPM bond carries more credit risk than the XOM bond.
Credit spreads for a category of bonds
In addition to looking at credit spreads for individual bonds, investors may also want to look at the credit spread of different categories of bonds.
For example, by comparing a group of corporate bonds (like high-yield bonds) versus Treasuries, you can get a picture of where the average highyield bond credit spread currently stands.
There are various indices available that enable this comparison. The iShares iBoxx $ High Yield Corporate Bond ETF (HYG), which tracks the
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iBoxx $ Liquid High Yield Index, and the SPDR Barclays Capital High Yield Bond ETF (JNK), which tracks the Barclays Capital High Yield Very
Liquid Index, are popular ETFs tracking indices in the high-yield bonds category.
Similarly, in the leveraged loans category, the S&P/LSTA U.S. Leveraged Loan 100 Index (SPBDLL) is a popular measure that tracks the marketweighted performance of the largest institutional leveraged loans. The PowerShares Senior Loan Portfolio Fund (BKLN), with companies like H.J.
Heinz Company (HNZ) and Fortescue Metals Group (FMG) in its portfolio, tracks this index.
To find out more about the relationship between interest rates and credit spreads, read on to the next part of this series.

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Credit spreads: A fixed income investor's must-know guide Market Realist

Credit spreads: A fixed income investor's must-know guide (Part 2 of 6)

The relationship between interest rates and credit spreads

By Surbhi Jain - Disclosure Mar 25, 2014 9:00 am EDT

Interest rates and credit spreads

Interest rates for different types of bonds normally dont change by the same degree together. When theres a lot of uncertainty in the market,
investors tend to park their money in super-safe U.S. Treasuries, causing their yields to drop and prices to rise. On the other hand, in times of
uncertainty, investors expect higher returns from high-yield bonds to compensate for the increased risk, causing their yields to rise and the prices to
drop. So even though Treasury yields are falling, the credit spread for high-yield bonds is getting wider.
Accordingly, examining credit spreads gives investors an idea of how cheap (a wide credit spread) or expensive (a narrow credit spread) the
market for a particular bond category or a particular bond is.

Credit spreads as an economic indicator

Credit spreads also give investors an idea as to where the economy is heading.
Improved economic conditions are signaled by improvements in company profitability and lower corporate default rates. This causes investors to
view investment-grade and high-yield corporate bonds more favorably, which causes the credit spread to contract. Moreover, improvement in the
economy prompts the Fed to hike interest rates in order to ward off inflationary pressure. This increase in interest rates causes Treasury yields to
spike, in turn tightening credit spreads.
The reverse happens in the case of an economic slowdown.
Market behavior
Bond investors try to anticipate changes in the fundamentals of the economy and the individual bond issuers they follow. Because of this trend,
credit spreads often move ahead of the economy, offering the intelligent investor some predictive power they can use to profit and avoid losses.
Changes in interest rates affect investor behavior to a great extent. Certain exchange-traded funds (or ETFs) like the ProShares Investment GradeInterest Rate Hedged ETF (IGHG), which has its major holdings in companies like Citigroup Inc. (C) and JP Morgan Chase & Co. (JPM), the
Vanguard Short Term Corporate Debt ETF (VCSH), and the PowerShares Senior Loan Fund (BKLN) are designed to protect the investors against
interest rate risk caused by inflation.

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To see how credit spreads change over time, read on to the next part of this series.

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Credit spreads: A fixed income investor's must-know guide (Part 3 of 6)

How credit spreads change with economic conditions

By Surbhi Jain - Disclosure Mar 25, 2014 1:00 pm EDT

Credit spreads change

As we reasoned in Part 2 of this series, credit spreads tighten with improvements in economic conditions and widen with deteriorating economic
conditions. You can see good evidence of these trends in spreads behavior during the credit crisis of 20082009.

The chart above shows how the Bank of America Merrill Lynch U.S. Corporate 3-5 Year Option-Adjusted Spread rose from 2008 through 2009.
This was a time when the sub-prime crisis had adversely affected the U.S. economy. The BofA Merrill Lynch US Corporate 3-5 Year Option
Adjusted Spread Index measures the credit spread between the average corporate bond with a maturity of three to five years and the average
Treasury of the same maturity range.
The three-to-five year corporate bond spread was below 1% until middle-to-late 2007, when the market started to get nervous leading up to the
financial crisis. The credit spread skyrocketed, reaching a high of about 7% at the height of the financial crisis. This was when Lehman Brothers
went bankrupt, in September 2008. After heavy government and Federal Reserve intervention, the markets stabilizedalthough spreads still
remained much higher than they were before the financial crisis, as weakness in the economy persisted.
For investors in ETFs, the performances of popular exchange-traded funds like the SPDR S&P 500 ETF (SPY), the iShares Core S&P 500 ETF
(IVV), and the iShares S&P 100 ETF (OEF)which track large-cap equities of companies like Apple Inc. (AAPL) and Exxon Mobil Corp. (XOM)
serve as a good indicator of the course the U.S. economy is taking.

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Credit spreads: A fixed income investor's must-know guide Market Realist

Credit spreads: A fixed income investor's must-know guide (Part 4 of 6)

Must-know: Do credit spreads only represent credit risk?

By Surbhi Jain - Disclosure Mar 25, 2014 5:00 pm EDT

Credit risk
While credit spreads do give you a good picture of the credit risk of one bond compared to another, its not the only factor they represent.
The spread is basically the premium that an investor in a bond expects over a benchmark bond (like a U.S. Treasury) for the additional credit (or
default) risk attached to it. However, there are other factors too that go into determining the premium that an investor in a bond demands over a
higher-grade benchmark bond. There are several other factors that combine with credit risk to make up the spread premium.

Municipal bonds
Take the case of municipal bonds. Municipal bonds are generally considered risk-free as Treasuriesand they often enjoy favorable tax treatment.
This results in most of them actually trading at a yield below the Treasury yield. This means the spread is negative.
The chart above shows the price performance of the iShares National AMT-Free Muni Bond (MUB), which tracks the performance of the investment
grade segment of the U.S. municipal bond market, against the iShares U.S. Treasury Bond (GOVT), which tracks the performance of public
obligations of the U.S. Treasury that have a remaining maturity of one year or more.
Corporate bonds
Similarly, many corporate bonds are illiquid, meaning it can be difficult to sell the bond once youve bought it because theres no active market for
the bond. Investors will therefore require a higher premium over and above credit risk premium to compensate for the liquidity risk associated with
the bond. The premium is known as liquidity risk premium. The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) tracks the
performance of 600 highly liquid investment grade corporate bonds of companies like Verizon Communications (VZ) and General Electric (GE).
Other factors that affect credit spreads, in addition to credit risk, include the following.
The bonds duration: The higher the duration, the higher the perceived risk, and the higher the spread.
Embedded options such as callability: Investors require a premium for accommodating such options, increasing spreads.
Event risk (natural disasters, regulatory changes, et cetera): A negative event warrants a higher premium, and consequently a higher spread.
Liquidity: As we mentioned, the spread is directly proportional to the illiquidity of the bond.

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Credit spreads: A fixed income investor's must-know guide (Part 5 of 6)

Assessing high yield bond credit spreads so far in 2014

By Surbhi Jain - Disclosure Mar 26, 2014 9:00 am EDT

High yield bond credit spreads

As we discussed in parts 2 and 3 of this series, credit spreads tighten with improvements in economic conditions. The U.S. economy is recovering
from the 2009 recession, and macroeconomic indicators are positive as far as the countrys economic growth. Investor confidence, which had
plummeted, is regaining.
So credit spreads are tightening for corporate bonds, as the economy is showing signs of improvement, and the macroeconomic outlook is
positive. To read more about the U.S. macro-economic outlook for 2014, read the Market Realist series Must-know 2014 US macro outlook: The
crack in the debt ceiling.

The iShares S&P 100 ETF (OEF), which tracks the large-cap equities of companies like Apple Inc. (AAPL) and Exxon Mobil Corp. (XOM), serves
as a good indicator of the course the U.S. economy is taking.
Credit spreads for high-yield bonds have shown a declining trend.
The chart above depicts how credit spreads for ten-year BBB-rated high yield bonds have evolved since the beginning of the year. The ten-year
BBB spread is the premium (or excess return) that a ten-year BBB-rated bond pays over the ten-year Treasury bond yield.
Quantitative easing, the massive bond-buying program by the Fedthrough which the government invests substantial funds in purchasing its own
Treasury securitieshas led Treasury rates to an all-time low.
The capital market has become yield-thirsty on account of Treasury yields being at an all-time low. So investors are diverting their investments
towards high-yield bonds in search of better risk-adjusted yields.
Through the recent tapering initiatives, through which the Feds gradually reducing the amount of Treasury bonds and mortgage-backed-securities it
buys, yields on Treasury bonds should show an uptick. The taper is an indication of improvement in the economy, raising expectations for corporate
profitability. This is precisely why the high yield bond spread curve (in the chart above) was reversing its trend in early March.
The iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the SPDR Barclays Capital High Yield Bond ETF (JNK) are popular ETFs in the
high yield bond category.

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Credit spreads: A fixed income investor's must-know guide (Part 6 of 6)

Assessing leveraged loan credit spreads so far in 2014

By Surbhi Jain - Disclosure Mar 26, 2014 1:00 pm EDT

Leveraged loan credit spreads

While changes in interest rates may not prompt long-term investors in safe companies like Apple Inc. (AAPL) and Exxon Mobil (XOM) to react,
investors holding stocks of highly leveraged companies may want to evaluate their holdings.

Leveraged loans have also experienced an increase in fund flows as investors moved their funds from low-yielding Treasuries elsewhere. Since
both high-yield bonds and leveraged loans offer high interest rates, investors are primarily divided between the two on the basis of the risk theyre
willing to take. Investors demand higher yields from high-yield bonds vis--vis leveraged loans, as high-yield bonds are unsecured, whereas
leveraged loans are secured by a charge on the issuers assets. Consequently, the credit risk attached to high yield bonds is greater.
However, leveraged loans are loans issued to individuals or corporations with a considerable amount of existing debt, and they also have to
compensate for the default or credit risk associated with repayment by paying higher yields.
The chart above shows how credit spreads for leveraged loans have evolved since the beginning of the year. The leveraged loan spread measured
here is the difference between the S&P/LSTA U.S. Leveraged Loan 100 Index return and LIBOR1, which serves as a benchmark for most
leveraged loans.
The PowerShares Senior Loan Portfolio Fund (BKLN) is a popular ETF tracking the S&P/LSTA U.S. Leveraged Loan 100 Index. The
Highland/iBoxx Senior Loan ETF (SNLN) and the First Trust Senior Loan ETF (FTSL) are other popular ETFs in the leveraged loans category.
The Fed funds rate has been zero on the lower bound for quite some time now. The Fed has deliberately kept the Fed funds rate at near zero so
that its unconventional monetary policy, consisting of quantitative easing, is effective. This has also resulted in the LIBOR rate maintaining its low
figure.
For more on the Fed funds rate being zero-lower-bound, read the Market Realist article Why a zero lower bound is constraining the Fed funds rate.
More than one factor have led to funds diverting toward the leveraged loan market.
The capital market has become yield-thirsty on account of Treasury bond yields also being at an all-time low. Investors are therefore diverting their
investments towards leveraged loans in search of better yields.
With investor expectations of an interest rate rise, leveraged loans seem to be a safer bet, as they offer floating interest rates. Floating interest rate securities
are preferable in a rising rate environment, as their return rises with the market. Theyre effective in negating the effect of inflation or interest rate risk.

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However, as leveraged loans are based on LIBOR, and LIBOR has been low for a while now, the yield on leveraged loans was also low. In a low
interest rate environment, investors preference shifts towards fixed-rate high yield bonds. The outflow from leveraged loans has increased the
liquidity risk attached to them, leading to an increase in the risk premium commanded by these securities. The increased risk premium has led to
an uptick in yields, while LIBOR remains low. Consequently, spreads have risen since January.
To learn more about investing in fixed income securities, see the Market Realist series Tapering and Treasury yields: Important takeaways.
1. The London Inter-bank Offered Rate is the average interest rate paid by banks to borrow overnight from each other. Its estimated by the British Bankers Association, which
comprises the leading banks in London.

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2013 Market Realist, Inc.

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