Factors That Influence Credit Yield Spreads

Fundamentals of
Credit Analysis
Credit Yields and Spreads
Describe factors that influence the level and volatility of
yield spreads
The yield on a corporate bond is determined by:
Real
Expected Maturity Liquidity Credit
risk-free + + + +
inflation
rate
premium premium spread
Present in default-free bonds Present only in

corporate bonds
Spreads on all corporate bonds can be affected by a number of factors, including:
• Credit cycle: As the credit cycle improves, credit spreads will narrow.
• Broader economic conditions: Weakening economic conditions will push investors
to demand a greater risk premium and wider credit spreads.
• Financial market performance overall: In weak financial markets, credits spreads
widen
• Others include broker’s & dealers wilingness to provide capital, and general market
forces.
Credit Risk
Yield for risky bond
Similar maturity
Yield for risk-free bond Spread Spread
Bench
mark
time
0
Credit Yields and

Spreads
Yield Spreads
↓Creditworthiness
➡ ↑Spread
Creditworthiness of
Lenders Borrower
Liquidity of markets Credit
Risk
Spread Premium
Liquidity
Premium
Benchmark
↓Liquidity ➡ ↑Spread
Credit Yields and

Spreads
Factors that Affect Yield Spreads
Credit Cycle
Economic Conditions
Financial Markets
Broker-Dealer Capital
Demand vs Supply
Spread
for higher quality issues
More affected
Spread and more
volatile
for lower quality issues
Credit Yields and
Spreads
Low Credit Risk
Market’s perception of
overall credit risk
Improved Credit Cycle
Credit Cycle
Spreads Narrow
Spread
Tightest spreads
Credit Yields and

Spreads
Low Credit Risk
Deteriorating
Market’s perception of
Credit overall credit risk
Cycle
Credit Cycle
High Risk!
Widest spreads
Spread
Spreads Widen
Tightest spreads
Credit Yields and

Spreads
Credit Cycle Factors that Affect Yield Spreads
Strengthening
Economic Conditions Economy
Rising corporate
cash flows
Spreads Narrow
Spread
Credit Yields and

Spreads
Weakening Economy
Economic Conditions
Greater risk
premium
Spread
Spreads Widen
Credit Yields and

Spreads
Low Volatility Market Condition
Economic Conditions
Strong Market
Financial Markets Condition
Investors "reach
for yield”
Spreads Narrow
Spread
Credit Yields and

Spreads
Economic Conditions
Weak Market
Conditions
Financial Markets
Spread
Spreads Widen
Credit Yields and

Spreads
Economic Conditions Broker–dealers’
willingness to provide
Financial Markets
sufficient capital for
market making
Sufficient Capital
Spread Spreads Narrow
Credit Yields and

Spreads
Economic Conditions Broker–dealers’
willingness to provide
Financial Markets
sufficient capital for
market making
Capital is scarce
GFC 2008
Several broker–dealers failed
➡Capital greatly reduced
➡Spreads ↑ significantly
Spread Spreads Widen
Credit Yields and

Spreads
Economic Conditions
Financial Markets
Demand > Supply

Demand vs Supply
Spread Spreads Narrow
Credit Yields and

Spreads
Economic Conditions
Financial Markets
Demand vs Supply
Supply > Demand
Heavy new issue supply

➡Insufficient demand to soak
up new supply
➡Spreads ↑
Spread Spreads Widen
Credit Yields and

Spreads
Credit Cycle
Economic Conditions
Financial Markets
Demand vs Supply
Spread
for higher quality issues
More affected
Spread and more
volatile
for lower quality issues
Credit Yields and
Spreads
Price Impact from Δ Yield Spreads
Bond Price
Δprice Δprice ≈ -ModDur x ΔYTM
ΔSpread
Slope of line
= -ModDur Spread
YT
0 ΔYTM = ΔSpread + ΔBenchmark M
Credit Yields and

Spreads
Bond Price
Actual price-spread
relationship
Accurate for small ΔSpread
Δprice Δprice ≈ -ModDur x ΔSpread
Slope of line
= -ModDur
Spread
0 ΔSpread
Credit Yields and

Spreads
Bond Price
Convexity Actual price-spread Refer to lesson on

Adjustment “Approximate Modified Duration
relationship and Convexity Adjustment”
Δprice
Δprice ≈ -ModDur x ΔSpread + ½convexity x (ΔSpread)2
Slope of line
= -ModDur
Spread
0 ΔSpread
Credit Yields and

Spreads

Factors That Influence Credit Yield Spreads

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Factors That Influence Credit Yield Spreads

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Fundamentals of

The yield on a corporate bond is determined by:

Present in default-free bonds Present only in

Yield for risky bond

Yield for risk-free bond Spread Spread

Credit Yields and

Credit Yields and

Credit Yields and

Credit Yields and

Credit Yields and

Credit Yields and

Credit Yields and

Credit Yields and

Spread Spreads Narrow

Credit Yields and

Spread Spreads Widen

Credit Yields and

Demand > Supply

Spread Spreads Narrow

Credit Yields and

Heavy new issue supply

Spread Spreads Widen

Credit Yields and

Δprice Δprice ≈ -ModDur x ΔYTM

Credit Yields and

Δprice Δprice ≈ -ModDur x ΔSpread

Credit Yields and

Convexity Actual price-spread Refer to lesson on

Δprice ≈ -ModDur x ΔSpread + ½convexity x (ΔSpread)2

Credit Yields and

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