The higher the credit risk, the greater the required yield and potential return demanded by investors. Over time, bonds with more credit risk offer higher returns but with greater volatility of return than bonds with lower credit risk.
Yield spread is the difference in yield between two securities.
Yield spreads, especially credit spreads, become wider during economic contractions. In times of credit improvement or stability, however, credit spreads can narrow sharply as well. This is known as "flight to quality".
Factors that affect yield spreads include: the credit cycle, economic conditions, financial market performance, market making capacity, and supply/demand conditions.
How do spread changes affect the price of and return on these bonds? The impact depends on two factors:
A credit curve is essentially the spread over treasuries of various maturities for a single bond issuer. It is typically upward-sloping, meaning the longer the bond maturity, the wider the spread.
|BrettGardner10: Know return impact formula|
|Shaan23: Im letting this formula slide|
| robbiecow: This is the same formula we have been looking at. The best way to remember this formula is thinking of Taylor Series.|
(-1)*dP/dy + d^2P/dy^2
P = Price
f'(P) = duration
f''(P) = convexity
|Memeteau: thks robbie. I missed that f''(P) was convexity. I miss much stuff about maths. ;-)|
|sshetty2: nice one|