Corporate bonds, both investment grade corporate bonds and bonds of high yield issuers, trade on the secondary market at what is known as a yield to maturity.
This yield to maturity is equivalent to the risk premium assigned by the market to those particular bonds, depending on the prevalent credit risk being assigned, and is thereby trades at a spread differential between the bond itself and the underlying return (yield) on a risk-free asset. So for example, a single A rated bond will trade at a lower risk premium than a single B rated bond having identical maturity profiles as the perceived risk premium required by the market would be less for the lower risk investments.
But what is this spread really? It is the compensation for the risk of a corporate bond over an underlying market yield. The direction of corporate bond spreads is highly dependent on the underlying yield in benchmark bonds, more often than not referred to as risk-free rate. The benchmark for corporate bonds in EUR is the 10-Year Bund, the benchmark for corporate bonds in USD is the 10-Year US Treasury whilst the benchmark for corporate bonds in GBP is the 10-Year Gilt. Whilst it is technically incorrect to assume that government bonds issued by the governments of Germany, the US and the UK are free of credit risk, it is market practice for these types of bonds to be the gauge upon which corporate bond yields trade at a spread.
The benchmark for corporate bonds in EUR is the 10-Year Bund, the benchmark for corporate bonds in USD is the 10-Year US Treasury whilst the benchmark for corporate bonds in GBP is the 10-Year Gilt. Whilst it is technically incorrect to assume that government bonds issued by the governments of Germany, the US and the UK are free of credit risk, it is market practice for these types of bonds to be the gauge upon which corporate bond yields trade at a spread.
So for example, if the yield on the German 10-Year Bund moves from 0.50% to 0.60% in a day, this means that the yield on the risk-free benchmark rose by 10 basis points, and hence the Bund price fell. Simultaneously, if single B rated bonds move from 3.00% to 3.05%, this means that the yield on Single B rated bonds rose by 5 basis points and hence bond prices fell. However, what is important to note is the movement in yield differential. The spread between Single B rated bonds moved from 2.50% (3.00% - 0.50%) to 2.45% (3.05% - 0.60%), which effectively means that Single B rated bonds became more expensive in comparison to benchmark yields. Although B rated bonds declined in price, the spread differential narrowed which means that benchmark yields sold off more than the yields on B rated bonds. Spreads are therefore a relative comparison in yields between the rates of returns of a bond over the
However, what is important to note is the movement in yield differential. The spread between Single B rated bonds moved from 2.50% (3.00% - 0.50%) to 2.45% (3.05% - 0.60%), which effectively means that Single B rated bonds became more expensive in comparison to benchmark yields. Although B rated bonds declined in price, the spread differential narrowed which means that benchmark yields sold off more than the yields on B rated bonds. Spreads are therefore a relative comparison in yields between the rates of returns of a bond over the risk-free rate.
The common denominator in a spread comparison analysis and the movement in spreads is the yield on the benchmark. It is therefore of imperative importance for investors to know how European sovereign yields are performing if you are a holder of a corporate bond (investment grade and/or high yield bond), and more than that, what influences benchmark yields and why they are so important in the corporate bond market.
The recent decline in benchmark yields for example, have been driven by global factors, with US President Trump seems to be struggling to rescind Obamacare where global inflationary figures have been softer than expected. Earnings season has started strongly and has resulted in a marked increase for credit, pushing spreads tighter. What is important to note is that benchmark yields in the Eurozone have been volatile in recent weeks and have stabilised around the 0.5%, whereby previous levels hovered around the 0.30%. This, in my opinion, must not be overseen, and a sustainable increase in benchmark yields testing resisting levels could be yet another sign that yields are stabilising at higher levels than before.
Disclaimer: This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.