Credit spreads

Have you read about credit spreads lately and wondered exactly what it is? Below we provide a brief explanation.

Volatility in the world's financial markets is not only an equity issue, with bond yields also succumbing to the uncertainty and volatility. With underlying interest rates being cut by Central Banks, the second component (credit spread) of a corporate bond yield is widening as investors re-price risk.

A re-pricing of risk will not only impact existing bonds but also impact any new corporate issuance.

What are credit spreads?

The yield on a fixed income security is made up of two components.

• Firstly, the underlying interest rate i.e. the five year swap rate or five year Government bond rate, which matches the bonds maturity.
• Secondly, the yield also contains a credit spread. This credit spread is the measure (usually measured in basis points*) of the credit risk of the corporate issuer. The higher the credit spread the riskier the corporate and therefore the higher the yield on the corporate bond.

* Basis point or bps is a unit of measure that represents the percentage change of a financial instrument, such as a change in bond yields. One bps equals 0.01%.  

There is a strong correlation between credit spreads and share price movement. Companies and analysts also report key credit ratios such as debt to debt plus equity, and debt to EBITDA (earnings before interest, tax, depreciation and amortization), both of which have been impacted by the reduction in equity values and falling earnings (EBITDA). Once these ratios deteriorate credit spreads widen.

Where a security ranks can determine the volatility of the credit spread

The riskier a corporate is deemed to be will be reflected in its credit spread and the appropriate credit rating (if the security and corporate have one) will also reflect the likelihood of default. An important distinction in regards to where the fixed income security sits within the corporates capital structure is imperative. Not only will its ranking determine the order in which investors are paid out in a liquidation scenario but it will also indicate how the credit spread will behave in times like we now find ourselves in. The lower the ranking and the closer the fixed income security sits to common equity, the more extreme the moves in credit spreads is likely.

In good times risk is always priced too low

The world's financial markets have been providing positive returns for a long time now and as a consequence the price of risk has fallen as the memory of the painful Global Financial Crisis (GFC) fades. Credit markets have reacted swiftly to COVID-19 with investors wanting a higher return for the higher risk as corporates around the globe face difficult trading conditions.

In summary, credit markets will...

The credit markets will settle down eventually but it will likely take time to reach the same levels as prior to the start of the recent market turmoil. Some sectors (oil and gas and the airline industry) may take significantly longer. Even though credit spreads were heading lower and lower prior to COVID-19, they were still much higher than pre-GFC levels. This illustrates just how long it may take.

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