Credit Spreads Expected to Tighten for Corporate Bonds in 2011

Gross investment yields on fixed-income instruments in particular, corporate bonds are a function of two components: current yields on a risk-free benchmark and a spread premium. The primary contributor to the spread premium is the credit spread. Credit spread may be defined as the additional yield an investor receives for a security with credit risk, over the yield it would receive for a risk-free security, such as U.S. Treasuries. Credit risk varies, depending on credit quality ranging from speculative (or high-yield; that is, rated below BBB-/Baa3) to investment grade (or high-grade; that is, rated BBB-/Baa3 and higher). Generally, the higher the credit risk, the wider the spread; that is, the more investors want to be compensated for the credit risk of the investment.

The duration of a corporate bond also is a determinant of credit spread. The longer the bonds maturity, the more likely an adverse corporate or economic event could occur or, from an investors standpoint, the lower confidence level that something will not occur that has the potential to negatively (or positively) affect the credit risk of the bond. Therefore, bonds with longer duration, all other factors being the same, are compensated via additional spread.

Factors That Impact Credit Spread

Corporate bond credit spreads also take into account other factors in addition to credit risk and duration. One of these factors is call (or prepayment) risk; while not all corporate bonds have this feature, it represents the ability of a company to call the bond, or repurchase the bond from investors (by paying it off) after a minimum time period as defined in the bond offering. Often, companies call bonds when interest rates decrease, so that they can reissue the debt at a lower interest rate (in effect, refinance). Bonds that have call risk are compensated via a wider spread, resulting in a higher yield to investors. In theory, this compensates the investor for the possibility that they might need to reinvest the cash at a lower yield. Call provisions became prevalent in the late 1970s during a period of sustained high interest rates. Premiums for this call risk became the norm in the early 1980s, as investors realized that they had not been adequately compensated for this risk.

Event risk is another factor that impacts corporate bond credit spread, and it varies by industry. Event risk represents the risk of a natural disaster, regulatory change or corporate transaction, the initiation of which is independent of the operations of the company, which could cause a credit rating downgrade to the bond. Bondholders are compensated for this through a wider spread, as they demand more reward for this risk.

The liquidity of a bond also plays a role in spread differential. Bonds that trade easily, and whose prices are readily available, tend to have narrower spreads than bonds that are not traded often and, therefore, are less liquid and difficult to price. Liquidity is an advantage for bondholders, as it implies that the bond can easily be traded for cash or other investments. Consequently, liquid bonds are deemed less risky. On the other hand, this liquidity premium is attractive to investors, such as insurance companies, that tend to be more inclined to a buy-and-hold investment strategy.

Economic Influences on Credit Spreads

Regardless of credit quality, economic conditions in the United States can influence the direction of credit spreads. In a recession, spreads tend to widen for high-yield and investment-grade bonds to compensate for default and other risks that could negatively impact a companys ability to pay full and timely debt service. In a growing economy, spreads tend to compress, as corporate debt is perceived as less risky, especially when company profits are on the rise. Market dynamics of supply and demand also influence credit spreads over time. According to Moodys, cash flow growth amid corporate borrowing restraint and accommodating monetary policy and forthcoming fiscal stimulus should aid in spread tightening throughout 2011. This lower level of activity on the new issue front will be matched with an increased supply of funds to be invested as retail investors gain greater confidence in the economy.

In addition, world events can impact credit spreads, particularly by industry. Earlier this year, economists predicted that the United States was well on its way to recovery; however, given the recent crises in Japan, turmoil in Libya and the Middle East, and sovereign debt issues, the status of the U.S. and the global economy is uncertain. For example, recent turmoil in Libya and the Middle East has resulted in a widening of high-yield bond spreads for the airline and chemicals industries, according to Moodys research. The U.S. housing crisis has resulted in spread widening for the retail and housing sectors high-yield debt. The crises in Japan have impacted its supply chain, leaving its overseas customers and trading partners uncertain about shipments and deliveries. As a result, certain industries in the United States could be impacted, such as auto and electronics. Generally, concerns about volatility can create supply/demand imbalances with a flight to quality.

Investment-Grade vs. High-Yield

Overall, spreads for high-yield and investment-grade were projected to tighten throughout 2011; however, this was before the earthquake and tsunami disaster in Japan and before military air strikes occurred in Libya. As default rates climbed when the financial crisis emerged around 2007, spreads on high-yield (or junk bonds) correspondingly widened. Then, in the beginning of 2010, credit spreads narrowed, due in part to improved U.S. economic activity. However, by the spring of 2010, spreads widened once more, due in part to sovereign debt concerns; this was followed by a market rally that attracted investors back into high-yield bonds. By November 2010, according to Bank of America Merrill Lynch research, high-yield bonds traded tighter relative to investment-grade bonds as investors preferred the higher returns of the riskier asset type.

The high-yield bond spread as of mid-March 2011 was approximately 517 basis points (bps) according to Standard & Poors, compared to about 600 bps as of December 2010. Standard & Poors research stated that, despite some volatility in high-yield spreads that occurred in the month of March, high-yield spreads have actually tightened since the beginning of 2011 to levels not seen since late 2007. Industry analysts expect high-yield spreads to tighten by 120 bps to 150 bps by year-end 2011, to 320 bps to 350 bps.