Do Credit Risk Spreads Indicate Problems or Opportunities?

Thursday, October 22, 2009

Percent symbolYesterday we used an interest rate spread to evaluate the Federal Reserve Boards activities and to get an understanding of where fixed-income investments might be headed. Today, let’s look at spreads to evaluate credit risk – the risk of bonds not issued by the US governement. These spreads can provide an insight into expected economic growth, company soundness and investor risk “tolerance” (i.e., the willingness of investors to take on risk). Here is what the spreads are telling us now…

First, let’s talk about using spreads. Bonds are well grouped into risk categories. By subtracting one group’s yield from another, we get a spread that represents the additional amount bond investors require to take on added risk. There are groups by maturity that can measure “interest rate risk” – the chance for gain or loss from a change in interest rates. The second, what we are looking at here, is “credit risk” – the chance that the bond issuer will have difficulty paying off the bond.

Focusing on bond investors is valuable because they tend to be conservative. Unlike stock investors, bond holders cannot earn whopping returns if things work out, but they can lose a lot if things go wrong. When bond investors brag about their added returns, they use “basis points,” with a basis point equaling 0.01%.

The spreads we will examine are based on two Moody’s credit ratings: Aaa and Baa. The range is from Aaa (best) to C (worst). Aaa, Aa, A and Baa are considered “investment grade” ratings. Below Baa (i.e., Ba, B, Caa, Ca and C) are the “high yield” or “junk” bond ratings. By looking at Aaa and Baa, we get the range of investment grade yields. Here are Moody’s definitions of each rating:

Aaa – Obligations rated Aaa are judged to be of the highest quality, with minimal credit risk.

Baa – Obligations rated Baa are subject to moderate credit risk. They are considered medium grade and as such may possess certain speculative characteristics.

Now, let’s look at the spreads. Comparing Aaa bonds to US Treasury 10-year bonds gives us the extra yield required for the best-rated bonds (US Treasury bonds are considered to have no credit risk). Then, comparing Baa to Aaa bonds gives us the extra yield required for riskier, but still investment grade, bonds. Here are those spreads over the past twenty-five years.

Credit Risk Spreads

Fittingly, on Halloween last year, the spreads hit their highest, and scariest, levels. Then, as positive actions took effect, the panic ebbed, and the spreads returned to a more normal, albeit high, level. What we would normally conclude is that bond investors currently view credit risk seriously, requiring added yield comparable to that of other worrisome times in the past. However, there are some mitigating items this time:

First, because so many investment grade bonds were downgraded over the past year, there remains some uncertainty about the accuracy of the current ratings. This would effect both spreads.

Second, the Fed is buying large amounts of longer term US Treasury bonds and is having some effect on lowering those yields. This would increase the Aaa-US Treasury bond spread.

Supporting the notion that credit risk has improved more than the spreads show are the following items:

The financial system and markets are functioning fairly smoothly

The economy is improving

Companies are financially sound overall

Probably most important – corporations are issuing bonds, and investors are willing buyers. Corporations tend to time their bond issuances well, so they view today’s spreads as acceptable and overall interest rates as desirable (low).

So, the current credit risk yield spreads appear appropriate, neither indicating future problems nor representing a special buying opportunity.

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