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Subject 6. The Term Structure of Credit Spreads PDF Download
The term structure of credit spreads corresponds to the credit spread with different maturities. The key determinants are:

1. Credit quality. High-yield bond tend to have a steep credit spread curve, because contractual cash flows becomes less certain, the longer the maturity.

2. Financial conditions of the economy. Stronger economy -> higher benchmark yields -> lower credit spreads. The credit spread curve tends to become steeper and widen in conditions of weak economic activity.

3. Market supply and demand dynamics. The most frequently traded securities tend to determine the shape of the curve.

4. Company-value model results. Any microeconomic factor, such as equity volatility, that affects the implied default probability can change the shape of the credit spread curve.

Two more important considerations are:
  1. the appropriate risk-free or benchmark rates used to determine spreads.
  2. the all-in spread over the benchmark itself - only senior unsecured general obligations of an issue should be considered.
The change in market expectations of default over time is a key determinant of the shape of the credit curve term structure. If the expectation of default is stable over time, we should see a flat curve. An upward-sloping curve implies investors seek greater compensation for assuming issuer default over longer periods.

Issuer- or industry-specific factors, such as the chance of a future leverage-decreasing event, can cause the credit spread curve to flatten or invert.

When a bond is very likely to default, the recovery rate instead of the credit spread should be used to assess the credit risk.

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