Fixed Income instruments, also known as bonds, issued by companies are known as Corporate Bonds.
Depending on the risk profile of the bond issuer, these can take various forms, namely Investment Grade Corporate bonds and/or High Yield bonds, and are generally issued on the primary market and trade on the secondary market.
These instruments are issued at a specific price with a given coupon (rate of interest) and trade at what is generally known in the financial world as a Yield to Maturity. The YTM is the most commonly and widely used measure of bond returns (yield).
It is the yield (return) that investors lock in (crystallise) when subscribing to or purchasing a bond, and is equivalent to the cost being assigned by the market on those particular bonds.
The market risk premium is a critical criteria in the assessment of market yields and is dependent upon a number of factors, amongst which is the underlying credit risk being assigned to a particular bond issuer as well as other similar bonds issued by that issuer.
In other words, the risk premium dictates the rate (yield) at which a bond trades, i.e. the difference in the yield of a bond and a particular benchmark bond, generally a riskless bond such as a German Bund or a US Treasury.
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.
In his/her critical analysis when investing in a bond, particularly those investing in the international bond market, it is of extreme importance to grasp the concept that bonds trade at a spread (and not at a price).
A bond trading at a spread is, explained in the simplest of ways, the compensation (risk premium) for the risk of a corporate bond over an underlying market yield.
The magnitude and direction of corporate bond spreads are highly dependent on the underlying yield in benchmark bonds, which is generally termed as the risk-free rate of a particular bond.
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 speaking, it is not a correct assumption 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.
Putting numbers into practice, let’s say that the yield on the German 10-Year Bund moves from 0.15% to 0.30% in a day; this means that the yield on the risk-free benchmark for EUR denominated bonds rose by 15 basis points, and hence the price of the German Bund price fell.
Simultaneously, if double B rated bonds move from 3.00% to 3.10%, this means that the yield on double B rated bonds rose by 10 basis points and hence bond prices for double-B rated bonds in EUR declined.
However, what one must keep in mind is to study the trend in the movements in yield differentials.
The spread between Double B rated bonds moved from 2.85% (3.00% - 0.15%) to 2.80% (3.10% - 0.30%), which effectively means that Double B rated bonds became more expensive in comparison to benchmark yields; in financial jargon, the spread on double B rated bonds tightened vs the benchmark yield.
Hence, although BB 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.