As we discuss in our article “Credit Spread Basics”, interest rates and credit spreads both change over time. All else being equal, if interest rates on treasuries move so will interest rates on all other types of bonds. However, often times all else is not equal, which is the reason why there is not a direct 1 to 1 relationship between movements in treasury yields and changes in yields on other types of bonds. This is also the reason why credit spreads change over time.
How Changes in Economic Condition Affect Credit Spreads
Improved economic conditions normally accompany improvements in company profitability, which lowers corporate default rates. This causes investors to view investment grade and high yield corporate bonds more favorably, which causes their interest rates to fall. As money flows into riskier assets such as corporate bonds, it flows out of safer assets like US treasuries, causing their yields to rise. As economic conditions improve, interest rates on corporate bonds fall, interest rates on treasuries rise, and their credit spread tightens (gets smaller).
Conversely, as economic conditions deteriorate company profits fall and losses rise, which increases default rates. This causes interest rates on corporate bonds to rise as investors demand more compensation for the additional risk involved. As money flows out of riskier assets such as corporate bonds it flows into safer assets such as US Treasuries, causing their interest rate to fall. As interest rates on corporate bonds are rising, and interest rates on treasuries are falling, their credit spread widens (gets bigger).
In addition to what’s happening in the economy as a whole, more “micro” factors also come into play with credit spreads of individual issues. These include:
- A negative/positive outlook for the issuer’s industry group.
- A competitive disadvantage/advantage for the issuer.
- Expectations of a ratings downgrade/upgrade
- A deteriorating/improving business or financial trend for an industry or issuer
- An issue with less/more relative market liquidity
As the above components can vary widely from one issuer to another, even issuers with the same credit rating can and often do have different credit spreads.
Example of Credit Spreads Changing Over Time
The recent financial crisis gives a great picture of how credit spreads change over time. Below is a chart of the BofA Merrill Lynch US Corporate 3-5 Year Option Adjusted Spread Index. The index shows the credit spread between the average corporate bond with a maturity of 3 to 5 years and the average treasury of the same maturity range.
As you can see from the chart, the 3 to 5 year corporate bond spread was below 1% until middle to late 2007 when the market started to get nervous leading up into the financial crisis. As the financial crisis intensified, the credit spread skyrocketed reaching a high of over 7% at the height of the financial crisis when Lehman Brothers went bankrupt in late 2008. After heavy government and Federal Reserve intervention the markets stabilized, although spreads are still much higher than they were before the financial crisis.
A final interesting point that the above analysis hints at, is that bond investors try to anticipate changes in the fundamentals of the economy and the individual bond issuers they follow. Because of this credit spreads will often move ahead of the economy offering the astute investor some predictive power that can be used to make profit and avoid losses.
