Bonds issued by corporations, better known as Corporate Bonds, (which are more commonly termed as either Investment Grade Corporate bonds and/or High Yield bonds), are issued on the primary market and trade on the secondary market. Bonds are issued and trade at what is known as a Yield to Maturity.
This measure of return (YTM) is the yield (return) that investors lock in when subscribing to or purchasing a bond, and is equivalent to the risk premium being assigned by the market on those particular bonds.
This market premium is dependent upon a number of factors, amongst which is the prevalent credit risk being assigned to a particular bond issuer and subsequent bonds issued by that issuer.
Therefore, the risk premium dictates the rate (yield) at which a bond trades, i.e the spread differential between the bond itself and the underlying return (yield) on a risk-free asset.
In the case for example of a single A rated bond, one would expect that the spread and risk premium will be lower than that of a single B rated bond having identical maturity profiles as the perceived risk premium required by the market would be theoretically less for the less risk investments and higher for the riskier assets.
For any bond investor, particularly those investing in international, it is important to grasp the concept of bonds trading at a spread. A bond trading at a spread is, put simply, the compensation for the risk of a corporate bond over an underlying market yield.
The direction and magnitude of corporate bond spreads are 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 the Eurozone is the 10-Year German Bund, the benchmark for US corporate bonds is the 10-year US Treasury whilst the benchmark for sterling denominated bonds is the 10-year UK Gilt.
Technically, it is incorrect to assume that government bonds issued by the governments of Germany, the US and the UK are free of credit risk, however it is market practice for these types of bonds to be the measure upon which corporate bond yields trade at a spread.
So for example, let’s say that the yield on the German 10-Year Bund moves from 0.35% to 0.45% in a day; this means that the yield on the risk-free benchmark for EUR denominated bonds rose by 10 basis points, and hence the price of the German Bund price fell.
Simultaneously, if single B rated bonds move from 2.75% to 2.80%, this means that the yield on Single B rated bonds rose by 5 basis points and hence bond prices for single-B rated bonds in EUR declined. However, it is of paramount importance to analyse and study the movements in yield differentials.
The spread between Single B rated bonds moved from 2.50% (2.75% - 0.35%) to 2.35% (2.80% - 0.45%), which effectively means that Single B rated bonds became more expensive in comparison to benchmark yields.
Hence, although B rated bonds declined in price as did the risk-free rate, the spread differential narrowed which means that benchmark yields sold off more than the yields on B rated bonds. Spreads and risk premia are therefore a relative comparison in yields between the rates of returns of a bond over the risk free rate.
It is therefore critical for a bond investor to know the trend in spreads, how benchmark rates are trading, and how they are impacting their bond portfolios. Grasping this concept is imperative in analysis what influences benchmark yields and why they are so important in the corporate bond market across all the rating spectrum.
Disclaimer: This article was issued by Mark Vella, investment manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view 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.
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