The credit spread is the excess premium over the government or risk- free rate required by the market for taking on a certain assumed credit exposure. Exhibit 2.4 shows the credit spread in January 2003 for industrial corporate bonds with different ratings (AAA, A, and BBB).
The benchmark is the on-the-run or “active” U.S. Treasury issue for the given maturity.
Notice that the higher the credit rating, the smaller the credit spread. Credit spread risk is the risk of financial loss resulting from changes in the level of credit spreads used in the marking-to-market of a product. It is exhibited by a portfolio for which the credit spread is traded and marked. Changes in observed credit spreads affect the value of the portfolio and can lead to losses for traders or underperformance relative to a benchmark for portfolio managers.
Duration is a measure of the change in the value of a bond when inter- est rates change. A useful way of thinking of duration is that it is the approximate percentage change in the value of a bond for a 100 bp change in “interest rates.” The interest rate that is assumed to change is the Trea- sury rate. For credit-risky bonds, the yield is equal to the Treasury yield plus the credit spread. A measure of how a credit-risky bond’s price will change if the credit spread sought by the market changes is called spread duration. For example, a spread duration of 2 for a credit-risky bond
EXHIBIT 2.4 U.S. Dollar Bond Yield Curves, January 2003
Source:Bloomberg.
means that for a 100 bp increase in the credit spread (holding the Trea- sury rate constant), the bond’s price will change by approximately 2%.
The spread duration for a portfolio is found by computing a market weighted average of the spread duration for each bond. The same is true for a bond market index. Note, however, that the spread duration reported for a bond market index is not the same as the spread duration for estimating the credit spread risk of an index. For example, on April 17, 2003, the spread duration reported for the Lehman Brothers Aggre- gate Bond Index was 3. However, the spread duration for the index is computed by Lehman Brothers based on all non-Treasury securities. Some of these sectors offer a spread to Treasuries that encompasses more than just credit risk. For example, the mortgage sector in the index offers a spread due to prepayment risk. The same is true for some subsectors within the ABS sector. Lehman Brothers does a have Credit Sector for the index. For that sector, the spread duration reflects the exposure to credit spreads in general. It was 1.48 on April 17, 2003 and is interpreted as fol- lows: If credit spreads increase by 100 bps, the approximate decline in the value of the index will be 1.48%.
Fundamental Factors that Affect Credit Spreads
To understand credit spread risk it is necessary to understand the funda- mental factors that affect credit spreads. These factors can be classified as macro and micro.
Macro Fundamentals
The ability of a corporation to meet its obligations on its debt depends on its expected cash flows. During prosperous economic times, investors expect that corporate cash flows will improve. In contrast, in an economic reces- sion, investors expect that corporate cash flows will deteriorate, making it more difficult to satisfy its bond obligations. Consequently, it is reasonable to assume that credit spreads are tied to the business cycle.23
The empirical evidence supports the view that the economic cycle has an effect on credit spreads. Exhibit 2.5 shows the yield spread between Baa rated and Aaa rated corporate bonds over business cycles dating back to 1919. Using the National Bureau of Economic Research’s definition of economic cycles, economic recessions are shaded in the exhibit. The evidence suggests that, in general, spreads tightened during the early stages of economic expansion, and spreads widened sharply during economic recessions.
23For a more detailed discussion of macro fundamental factors that affect credit spreads, see Chapter 10 in Crabbe and Fabozzi, Managing a Corporate Bond Port- folio.
Investors tend to be forward looking and therefore credit spreads react to anticipated changes in the economic cycle. For example, typi- cally credit spreads begin to widen before the official end of an eco- nomic expansion. Consequently credit spreads can change based on an anticipated change in the economic cycle that does not materialize.
Anticipating changes in economic cycles is, therefore, important in assessing an adverse change in credit spreads. There has been extensive research by economists to identify economic indicators that lead eco- nomic cycles, referred to as “leading economic indicators.” Exhibit 2.6 shows the 10 U.S. leading economic indicators used by The Conference Board.24 From the 10 leading economic indicators a leading index is constructed. The weighting used for each leading economic indicator to obtain the leading index is shown in the exhibit.
Moreover, some industries within the economy exhibit strong eco- nomic cycle patterns. As a result, credit spreads for industries can be expected to be affected by economic cycles. For example, the auto
24The Conference Board constructs a leading index for other countries, namely, Germany, Japan, Australia, France, Spain, and Korea.
EXHIBIT 2.5 Yield Spread Between Baa and Aaa Bonds
Source:Exhibit 1 in Chapter 10 of Leland E. Crabbe and Frank J. Fabozzi, Manag- ing a Corporate Bond Portfolio (Hoboken, NJ: John Wiley & Sons, 2002).
industry is more adversely impacted by a recession than other industries such as consumer staples.
Micro Fundamentals
At the micro level, the analysis of a potential change in the credit spread focuses on the fundamental factors that may alter the individual corpo- ration’s ability to meet its debt obligations. These are the same factors that the rating agencies use to assess the credit default risk of a corpora- tion that we discussed earlier in this chapter.