How bond prices, interest rates, and credit spreads correlate

Market Realist

Why credit risk is an essential value driver of high yield bonds (Part 5 of 5)

(Continued from Part 4)

An inverse relationship

Bond prices and interest rates have an inverse relationship. If an interest rate increases, the price on a bond declines, and vice versa. For example, if interest rates move up by one percentage point—such as from 5% to 6%—the price of a bond with a duration of five years will decline 5%, and a bond with a duration of ten years will decline about 10%.

As we can see in the chart above, the U.S. ten-year Treasury yield declined at the end of 2014, while the BAML Index (Bank of America Merryl Lynch U.S. High yield index) effective yield increased over the same period as a result of credit widening. The movement was more economy-driven. Generally, when the economy improves, interest rates on Treasuries increase and interest rates on corporate bonds fall. As a result, credit spreads tighten. Conversely, when the economy falls, corporate bonds become much riskier than usual, and their profits start falling. As a result, the interest rate on corporate bonds rises as investors demand a higher premium to remain invested in this asset class. And the interest rate on Treasury bonds tends to fall as investors flee to safety. This causes credit spreads to widen, meaning higher premium over the government bond.

To learn more about U.S. Treasuries, see the Market Realist series Why investors should look at floating rate notes as an option.

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