Chart of North America Investment Grade Credit Index
All domestic bonds that are not treasury issues contain some amount of default or credit risk. This risk means that these bonds must compensate the bondholder for assuming this risk by providing a yield greater than what a treasury security of the same maturity would pay. This yield premium is known as the credit spread. For example, if the 10-year treasury note is yielding 5% and a 10-year AAA rated corporate bond yields 5.75%, the credit spread is .75%.
The credit spread represents the market’s perceived creditworthiness of the bond issuer and will not only vary from one bond to another, but will fluctuate over time for the same bond. The credit spread is calculated based on the current on-the-run treasury.
The primary determinant of a bond’s credit spread is the bond’s credit rating. However, not all bonds of the same credit rating and maturity will trade with the same credit spread. Factors that can cause an issue’s credit spread to be larger/smaller than the credit spread of other issues of the same credit rating include:
- A negative/positive outlook for the issuer’s industry group
- A competitive disadvantage/advantage for the issuer
- Expectations of a ratings downgrade/upgrade
- A deteriorating/improving business or financial trend for an industry or issuer
- An issue with less/more relative liquidity
Since treasuries have no default risk, they represent the risk-free rate of return (though treasury bonds are subject to other risks such as interest rate and reinvestment risk.) Treasury yields have three components:
- The risk-free real yield
- The inflation premium that reflects the expected rate of inflation
- The volatility premium that represents the risk associated with the price sensitivity of longer maturity bonds to changes in interest rates
Non-treasury bonds have a fourth component, the credit risk premium, which we will cover in another lesson. Because treasury TIPS are indexed to inflation, their yield gives an indication of the risk-free yield.
There are a few factors that affect the price of treasuries including supply and demand, general economic activity, and budget and trade surpluses or deficits. However, the single most important factor is the general level of interest rates, and the general level of interest rates is mainly determined by the expected level of inflation.
It is obvious that if one was able to have a reliable indication of future changes in interest rates, then one could make considerable profits in the bond markets. Fortunately, there are some very good ways to get an indication of where interest rates are going, and we will discuss these rate indicators in future lessons.
There was a very interesting blog many of us enjoyed over the past couple years know as Across the Curve. The purpose of that on-line publication was to “inform and illuminate” readers about the movements of fixed income markets.
As we continue to build the BondSquawk community, we hope many of you will take the time to stop by and read what our traders are telling us about current and future market activity.
We are hoping to gather the same quality commentary and observations that made “Across the Curve” a pleasure to read.
A bond’s market price, like the price of any financial asset, represents the present value of the stream of future cash flows to the bondholder.
A dollar in your hand today is worth more than a dollar that you receive a year from now due to several factors:
You can deposit that money at a bank
Purchase an investment that will yield you a return for the next year. The present value is discounted by the rate of return you could earn on that dollar over the next year (the discount rate). Our example represents a one-time future payment, but the concept is the same for bonds that represent a stream of future payments. The discount rate for a bond is its yield.
The price of a bond is a function of the coupon of the bond relative to the market yield of equivalent bonds. For example, a bond with a coupon rate of 5% will be priced at par if the market yield is also 5%, if the market yield is below 5%, the bond will trade at a premium, and if the market yield is above 5% the bond will trade at a discount.
Since bond prices fluctuate with changes in market yields or the general level of interest rates, in order to determine the factors that influence bond prices we need to understand what factors influence the general level of interest rates.
Posted by John Adams on 
