Subject 5. Credit Risk vs. Return: Yields and Spreads

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.

  • The yield of a corporate bond = yield on a risk-free bond + yield spread
  • The yield spread here is composed of the liquidity premium and the credit spread: yield spread = liquidity premium + credit spread

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:

  • The basis point spread change
  • The sensitivity of price to yield as reflected by modified duration and convexity

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.

User Contributed Comments 6

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BrettGardner10: Know return impact formula
Shaan23: Im letting this formula slide
ldfrench: yuppppp^
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