Spread risk: Why credit ratings are a key risk determinant

Market Realist

Why credit risk is an essential value driver of high yield bonds (Part 2 of 5)

(Continued from Part 1)

Credit ratings

Credit ratings assess the credit-worthiness of a borrower and assign a grade based on the borrower’s business operation and financial stability. In the U.S., there are three major credit rating agencies (S&P, Moody’s, and Fitch) that assign credit ratings to issuers. (Issuers can be anyone from corporate to sovereign governments.) For all these agencies, AAA is considered the best credit quality.

Until 2011, the U.S. government enjoyed an AAA rating, which was later cut down to AA-plus by S&P. Credit agencies rate high yield bonds lower than Treasuries or investment-grade bonds, and due to the lower rating, investors demand a credit risk premium. Credit risk premium is the spread between the U.S. Treasury and other fixed income investments.

The probability of default (or PD) and loss-given-default (or LGD) associated with high yield bonds is indeed much higher than what’s associated with other asset classes.

The probability of default is essentially the likelihood of the issuer to default. Loss-given default assessments are opinions about expected loss given default on fixed-income obligations. They’re expressed as a percentage of principal and accrued interest at the time of default.

During the recent crisis of 2008, the default risk on high yield bonds soared. This essentially means that the probability of these issuers defaulting on the interest rate and principal payment was much higher than usual. In contrast, when the economy recovers, the default rate declines. This is because, firstly, the fundamentals on the company issuing high yield bonds get better, and secondly, investor outlook on the credit-riskiness of the bond improves. Currently, the default rate on the high yield bond is at 2.5%.

The above statement holds true from the credit risk perspective, but interest risk is another factor. So, in an improving economy, it becomes more likely that the Federal Reserve would increase the interest rate, and if that happens, the credit spreads tighten between U.S. Treasuries and high yield bonds.

For example, consider B-rated bonds yielding 6%. These are essentially bonds that have a high probability of default and a Treasury security with similar duration yielding 2%. The junk-bond risk premium, also know as “junk-Treasury spread” (or JTS), between the two will be 4%.

It’s more important to remember that in an environment of increasing interest rates, the spread between high yield bonds and risk-free Treasuries compresses.

We’ll take a closer look at the credit rating and yield relationship, which is inversely proportional. A lower credit rating means higher risk and higher yield, as investors look for the premium to take the risk and vice-versa. Let’s read on to Part 3 to learn more.

Continue to Part 3

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