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4.9 Effect of changes in credit spread and liquidity on yield-to-maturity of a bond and how

duration and convexity can be used to estimate the price effect of the changes The yield-to-maturity on a corporate bond is composed of a government benchmark yield and a spread over that benchmark. A change in the bond's yield-to-maturity can originate in either component or a combination of the two.

A change in the benchmark yield can arise from a change in either the expected inflation rate or the expected real rate of interest.

  • The inflation duration would indicate the change in the bond price if expected inflation were to change by a certain amount.
  • The real rate duration would indicate the bond price change if the real rate were to go up or down.

Credit risk includes the probability of default as well as the recovery of assets if default does occur. A credit rating downgrade or an adverse change in the ratings outlook for a borrower reflects a higher risk of default.

Liquidity risk refers to the transaction costs associated with selling a bond.

4.9.1 Effect of Changes in Credit Spread and Liquidity on Yield-to-Maturity of a Bond

and How Duration and Convexity Can Be Used to Estimate the Price Effect of the Changes A change in the spread can arise from a change in the credit risk of the issuer or in the liquidity of the bond.

For a bond with a given duration and convexity, the impact of changes in yield-to-maturity on the bond's price will be the same regardless of the source of the yield-to-maturity change.

The problem for a fixed-income analyst is that it is rare for the changes in the components of the overall yield-to-maturity to occur in isolation.

In practice, the analyst is concerned with the interaction between changes in benchmark yields and spreads, between changes in expected inflation and the expected real rate, and between changes in credit and liquidity risk.

For example, during a financial crisis, a "flight to quality" can cause government benchmark yields to fall as credit spreads widen.

An unexpected credit downgrade on a corporate bond can result in greater credit as well as liquidity risk.

Lesson Wrap-Up

This lesson should leave you able to explain the effect of changes in credit spread and liquidity on yield-to-maturity of a bond and how in a fixed-income context and connect it to the decisions made by issuers, investors, or analysts.

Review Prompts

  1. Explain effect of changes in credit spread and liquidity on yield-to-maturity of a bond in your own words.
  2. State one exam-style risk, valuation, or market implication of the effect of changes in credit spread and liquidity on yield-to-maturity of a bond and how.