Yield spreads on corporate bonds
We can think of the yield on an option-free corporate bond as the sum of the real risk-free interest rate, the expected inflation rate, a maturity premium, a liquidity premium, and a credit spread. All bond prices and yields are affected by changes in the first three of these components.
The last two components are the yield spread:
yield spread = liquidity premium + credit spread
Yield spreads on corporate bonds are affected primarily by five interrelated factors:
- Credit cycle: The market’s perception of overall credit risk is cyclical. At the top of the credit cycle, the bond market perceives low credit risk and is generally bullish. Credit spreads narrow as the credit cycle improves. Credit spreads widen as the credit cycle deteriorates.
- Economic conditions: Credit spreads narrow as the economy strengthens and investors expect firms’ credit metrics to improve. Conversely, credit spreads widen as the economy weakens.
- Broker-dealer capital: Because most bonds trade over the counter, investors need broker-dealers to provide market-making capital for bond markets to function. Yield spreads are narrower when broker-dealers provide sufficient capital but can widen when market-making capital becomes scarce.
- General market demand and supply: Credit spreads narrow in times of high demand for bonds. Credit spreads widen in times of low demand for bonds. Excess supply conditions, such as large issuance in a short period of time, can lead to widening spreads.
- Issuer’s financial performance: Developments that are positive for the issuer’s credit quality will narrow its yield spread, while developments that are negative for the issuer’s credit quality will widen its credit spread.Yield spreads on lower-quality issues tend to be more volatile than spreads on higher-quality issues