FRBSF Economic Letter
2004-36; December 10, 2004
What Determines the Credit Spread?
Although
the swings in economic measures during the last recession and recovery
were fairly modest, swings in financial markets were
quite large. Once financial markets found their footing, after
steep losses in 2000-2002, prices on virtually all traded financial
claims rose as the economic outlook improved. This pattern was
particularly true in the corporate bond market. In this Economic
Letter I describe the significant narrowing of bond spreads across
different sectors and ratings classes since the last recession.
I also discuss recent research on the determinants of relative
pricing in the corporate bond market.
The corporate bond market
A corporate bond is a
debt instrument issued by a legal corporate entity. Bonds differ
across many dimensions, including maturity,
collateral, and whether there is any optionality such as a call
provision embedded in the bond. Typically, corporate bonds have
maturities longer than 2 years. Shorter-term debt instruments include
commercial paper (less than 270 days) and medium-term notes.
The
U.S. corporate bond market is large, with $6.8 trillion in outstanding
corporate and foreign debt (that is, dollar-denominated
debt issued in the U.S.) in the fourth quarter of 2003. This total
is about two-thirds the amount of outstanding U.S. Treasury debt
and five times the amount of outstanding business loans at banks
in the U.S. The growth rate of net corporate debt issuance is approximately
12% per year since 1980, and appears to be less variable than the
net growth in business loans at banks.
Corporations differ in their
creditworthiness, and these differences are apparent in the pricing
of their bonds, as well as in whether
a particular firm is able to issue debt through the public markets
at all. Private ratings agencies (such as Moody's and Standard & Poor's)
provide guidance to investors on the credit quality of various
bond issues. The Standard & Poor's ratings scale ranges from
the more creditworthy investment grade debt (roughly BBB, A, AA,
and AAA) to less creditworthy speculative-grade debt (roughly CC,
CCC, B, BB). Today, approximately one-half of the rated corporate
bonds outstanding are BBB or better.
Recent behavior of credit spreads
 A bond's value
is usually quoted not in terms of its traded price, but in terms
of its yield, or the annualized holding period return
if an investor held the bond to maturity. Like yields on Treasury
securities, corporate bond yields embody a reward to investors
for forgoing consumption today and saving. But corporate yields
are almost always higher than yields on Treasuries of comparable
maturities because of the implicit default risk and a host of other
factors. The corporate spread, or sometimes just the credit spread,
is usually measured as the difference between the yields on a defaultable
corporate bond and on a U.S. government bond of comparable time
to maturity.
Figure
1 plots the behavior of various U.S. credit spreads and clearly
shows that credit spreads tend to widen in
recessions and
to shrink in expansions. The figure also illustrates an episode
where the spread changed in response to an event that was not immediately
related to the business cycle, specifically, the Russian default
in 1998. This event triggered a huge move in spreads, as markets
seized up in a liquidity crisis, even though the U.S. corporate
bond market did not see a significant jump in defaults.
Given the large change in credit spreads over
the past two years, it is useful to identify the sectors and risk
classes behind the
improving conditions in the bond market. I focus on high-yield
bonds, the segment with the largest fluctuations over the period.
I use the Merrill Lynch High-yield Master, which consists of 1,966
bonds rated BB or lower. All spreads are calculated as the difference
between a corporate yield and the yield on the 10-year constant
maturity Treasury note.
 Figure
2 plots the time-series of spreads in some sectors that comprise
the high-yield index. The energy,
telecom, and utility
sectors have the largest representation in the High-yield Master
today, each accounting for about 10% of the index. Figure 2 depicts
the narrowing in spreads following the 2001 recession, with spreads
on telecoms falling the most, from a high of 21 percentage points
in October 2002 to just 5 percentage points in July 2004. High-yield
bonds in the energy sector once traded at spreads of 10 percentage
points, but now have spreads of closer to 3 percentage points,
a mere 1 percentage point over the AAA spread.
Determinants of corporate spreads
Why does the
difference between yields on speculative-grade debt and investment-grade
debt vary by almost 10 percentage points over
the course of a fairly run-of-the-mill business cycle? One possibility
is that distinctions between ratings classes change over the business
cycle, so that the difference in default risk between, say, a BBB-rated
bond and an AA-rated bond is less in good economic times than in
bad. The evidence does not support this conclusion, however. Measures
of a company's probability of default do not appear to be as variable
as the credit spread over time. Indeed, there is now an established
literature on estimating just how much of the so-called credit
spread is due to credit or default risk. To get a sense of the
range of estimates, Amato and Remolona (2003) note that average
BBB corporate spreads were nearly ten times higher than average
losses from default between 1997 and 2003. Using more sophisticated
statistical methods, Elton et al. (2001) report that expected losses
from default can account for less than 20% of the credit spread.
Finally, Longstaff et al. (2004) estimate that default risk accounts
for more than 50% of the credit default swap spread.
Though there is a range of estimates on the size
of the non-default risk component, it is generally accepted now
that there is more
to the corporate spread than just credit risk. This observation
has led researchers to search for other determinants of the spread.
One other obvious difference between corporate bond yields and
government bond yields is their tax treatment; interest income
paid on corporate bonds, but not government bonds, is taxable at
the state level. The top marginal state tax rates generally range
from 5%-10%. Elton et al. (2001) find that, depending on the ratings
class, taxes can account for anywhere from one-quarter to three-quarters
of the difference in the spread between corporate and government
bonds.
Another difference is that the credit spread contains
some compensation for the general illiquidity of the bond market.
Investors
typically
incur larger round-trip trading costs in the corporate bond market
than in the U.S. equity market. But market liquidity is not constant
over time. The recent performance of corporate bonds offers a nice
opportunity to see this point. As the economy weakened and default
rates spiked, investors allegedly reduced their demand for high-yield
securities and sought safe-haven investments. In order for the
market to clear, spreads on corporate bonds had to widen. As the
general economic weakness became apparent, however, monetary policy
became very accommodative. The extended period of low interest
rates and the recovery presumably increased liquidity to the high-yield
sector, and spreads converged.
One way to get a rough estimate of
the size of this liquidity effect is to estimate a relationship
between the yields on corporate bonds
and variables meant to proxy for current and future economic health
of firms. Lacking a good variable with which to identify the aggregate
risk or liquidity premium for the bond market, the deviation of
the actual spread from the model-predicted spread can be interpreted
as an upper bound for this component of the spread.
I start with
a simple model to explain the monthly change in spread of the Merrill
Lynch High-yield Index over the 10-year Treasury
yield. The model is similar in spirit to the one estimated by Collin-Dufresne
et al. (2001); the main difference is that this model uses an aggregate
index, and not a collection of individual corporate bonds. The
variables used to explain the change in the high-yield spread are
the previous monthly change in the spread, the last month's level
of the spread, the monthly return on the S&P 500, and the change
in the S&P 100 volatility index (a measure of stock market
investor uncertainty about future stock returns). Other lags of
the spread and other economic variables were considered, such as
the change in the federal funds rate, the change in the speculative-grade
default rate, and the change in the slope of the risk-free term
structure. But these variables proved to add little to the specification
after the other variables were already in place. Presumably, the
change in the default rate failed to be significant in the model
because of the inclusion of the lagged spread terms and the more
forward-looking stock market variables that should capture expectations
of future default rates.
 The model includes variables that account for
the general economic conditions and future assessments of risk.
Figure 3 shows the actual
high-yield spread compared to the "fitted spread," or
the spread generated by the model. The fitted spread moves with
the actual spread, indicating that the choices of variables to
proxy for the economy seem to be well-founded. But the fitted spread
is not as variable as the actual spread. In bad economic times,
investors require more compensation for risk than can be accounted
for by the fundamentals in this model. Likewise, in good economic
times, actual spreads tend to be lower than those predicted by
the model. These estimates should be viewed as back-of-the-envelope,
and do not imply mispricing; they do, however, illustrate in a
simple way that a large portion of the credit spread cannot be
explained by previous dynamics in the spread, or by reasonable
proxies for risk captured in stock market variables. Moreover,
the deviation of the model-based spread seems to be related to
the cycle.
Conclusion
The narrowing of corporate bond spreads
across virtually all ratings classes and business sectors is
a strong vote of confidence
in
the economic recovery. However, the episode also serves as
a reminder of the keen research interest in the determinants
of corporate
bond spreads. High-yield spreads are clearly tied to fundamentals
such as future expected default rates. But spreads are also
related to market liquidity in ways that are not yet well understood.
John
Krainer
Economist
References
[URLs accessed November 2004.]
Altman, E., and G. Bana. 2004. "Defaults and Returns on High-Yield
Bonds." Journal of Portfolio Management (Winter) pp. 58-73.
Amato, J., and E. Remolona. 2003. "The
Credit Spread Puzzle." BIS
Quarterly Review (December) pp. 51-63.
http://www.bis.org/publ/qtrpdf/r_qt0312.pdf
Collin-Dufresne,
P., R. Goldstein, and S. Martin. 2001. "Determinants
of Credit Spread Changes." Journal of Finance 56, pp. 2,177-2,208.
Elton,
E., M. Gruber, D. Agrawal, and C. Mann. 2001. "Explaining
the Rate Spread on Corporate Bonds." Journal of Finance 56,
pp. 247-277.
Longstaff, F., S. Mithal, and E. Neis. 2004. "Corporate
Yield Spreads: Default Risk or Liquidity? New Evidence from the
Credit-Default
Swap Market." Working Paper 11-03, UCLA. http://www.anderson.ucla.edu/documents/areas/fac/finance/11-03.pdf
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