5.4 Credit Risk and Return: Yields and Spreads

5.4.1 Factors influencing the level and volatility of yield spreads

Typically, the higher the credit risk, the greater the return potential and the higher the volatility of that return.

The yield on a bond can be decomposed as:

Yield = RFRr + E(i) + mp + lp + cs Yield Spread = lp + cs Where: RFRr – Real Risk-free rate E(i) – Expected Inflation rate Mp, lp – Maturity premium; Liquidity premium Cs – Credit spread The yield on a credit-risky bond comprises the yield on a default risk-free bond with a comparable maturity plus a yield premium, or "spread," that comprises a credit spread and a liquidity premium.

The impact of spread changes on holding period returns for credit-risky bonds is a product of two primary factors: the basis point spread change and the sensitivity of price to yield as reflected by (end-of-period) modified duration and convexity.

The market's willingness to bear risk will affect each of these components. In general, however, it is not possible to directly observe the market's assessment of the components separately- analysts can only observe the total yield spread/yield.

Factors that Affect Spreads on Corporate Bonds Spreads on bonds can be affected by these factors:

• Credit cycle – As the credit cycle improves, credit spreads will narrow.
• Broader economic conditions – Weakening economic conditions will push investors to desire a greater risk premium and drive overall credit spreads wider.
• Financial market performance overall, including equities – In weak financial markets, credit spreads will widen, whereas in strong markets, credit spreads will narrow.
• Broker/dealers' willingness to provide sufficient capital for market making.
• General market supply and demand – In periods of heavy new issue supply, credit spreads will widen if there is insufficient demand.

5.4.2 Determination of Return Impact of Spread Changes

The price impact (Volatility) from spread changes is driven by two main factors:

• Modified duration (price sensitivity with respect to changes in interest rates) of the bond –
• Magnitude of the spread change For larger spread changes (and thus, larger yield changes), the impact of convexity needs to be incorporated:

Price Impact ~ -MD x DeltaSpread + 1/2 x Conv x (DeltaSpread)2

• The negative sign in this equation reflects the fact that because bond prices and yields move in opposite directions, narrower spreads have a positive impact on bond prices and thus returns, whereas wider spreads have a negative impact on bond returns.

For small spread changes, the above formula without convexity is often used.

The effect on return to the bondholder depends on the holding period used for calculating the return.

5.4.3 Special Considerations When Evaluating the Credit of High Yield, sovereign, and

Municipal Debt Issuers and Issues 5.4.3.1 High-Yield Analysis Special Considerations Companies with weak balance sheets and/or business profiles have a lower margin for error and greater risk of default relative to higher-quality investment-grade names. And the higher risk of default means more attention must be paid to recovery analysis (or loss severity, in the event of default). High-yield analysis is typically more in-depth than investment-grade analysis and thus has special considerations, such as:

• Greater focus on issuer liquidity and cash flow
• Detailed financial projections
• Detailed understanding and analysis of the debt structure
• Understanding of an issuer's corporate structure
• Covenants – Key covenants for high-yield issuers may include: Change of control; restricted payments; Limitations on liens and additional indebtedness; Restricted versus unrestricted subsidiaries.
• Equity-like approach to high-yield analysis 5.4.3.2 Sovereign Credit Analysis Special Considerations Some Important considerations in sovereign credit analysis include:
• Institutional effectiveness and political risks
• Effectiveness, stability, and predictability of policy making and institutions, as regards:
• Successful management of past political, economic, and/or financial crises
• Ability and willingness to implement reforms to address fiscal challenges
• Predictable policy framework
• Absence of challenges to political institutions
• Checks and balances in the system
• Absence of corruption
• Unbiased law enforcement and respect for rule of law and property rights
• Independent/unfettered media and sources of economic data
• Perceived commitment to honor debts
• Economic structure and growth prospects
• Income per capita
• Trend growth prospects
• Sources and stability of growth
• Size of the public sector relative to private sector
• Growth and age distribution of population
• External liquidity and international investment position
• Status of currency
• External liquidity
• External debt
• Monetary flexibility
• Ability to use monetary policy to address domestic economic objectives (e.g., growth), including exchange rate regime
• Credibility of monetary policy
• Operationally independent central bank
• Clear central bank mandate/objectives
• Track record of low and stable inflation
• Central government's ability to issue substantial long-term, fixed-rate debt in domestic currency
• Effectiveness of monetary policy transmission via domestic capital markets
• Well-developed banking system
• Active money market and corporate bond market
• Greater reliance on market-based policy tools and limited reliance on blunt, administrative policy tools
• Fiscal performance, flexibility, and debt burden
• Trend change in general government debt as a percent of GDP
• Perceived willingness and ability to increase revenue or cut expenditure to ensure debt service
• General government interest expense as a percent of revenue
• Net general government debt as a percent of GDP
• Contingent liabilities arising from the financial sector, public enterprises, and guarantees Credit rating agencies often distinguish between domestic and foreign bonds, with domestic bond ratings as much as two notches higher.

5.4.3.3 Non-Sovereign (Municipal) Credit Analysis Special Considerations The credit analysis of non-sovereign general obligation (GO) bonds is similar to sovereign debt analysis.

• The economic analysis of non-sovereign government GO bonds focuses on employment, per capita income, per capita debt, the tax base, demographics, net population growth, and the local infrastructure.
• Analysis should look at the volatility and variability of revenues during times of both economic strength and weakness.

Revenue bonds, which are issued to finance a specific project, have a higher degree of risk than GO bonds because they are dependent on a single source of revenue.

• The analysis of these bonds is a combination of an analysis of the project and the finances around the particular project.
• The project analysis focuses on the need and projected utilization of the project, as well as on the economic base supporting the project.

Challenges in Non-Sovereign (Municipal) Credit Analysis

• Some municipalities must balance their operating budgets (i.e., exclusive of long- term capital projects) annually.
• Also, non-sovereign governments are unable to use monetary policy the way many sovereigns can.
• Disclosure by non-sovereign governments varies widely, with some of the smaller issuers providing limited financial information. Reporting requirements are inconsistent, so the financial reports may not be available for six months or more after the closing of a reporting period.

Lesson Wrap-Up

This lesson should leave you able to explain the credit risk and return: yields and spreads in a fixed-income context and connect it to the decisions made by issuers, investors, or analysts.

Review Prompts

1. Explain factors influencing the level and volatility of yield spreads in your own words.
2. Explain determination of return impact of spread changes in your own words.
3. Explain special considerations when evaluating the credit of high yield, sovereign, and in your own words.
4. State one exam-style risk, valuation, or market implication of the credit risk and return: yields and spreads.