Credit risk is the risk of increase in probability of default. Credit risk can either be in the form of a default where an issuer defaults on payment of interest and principal or in the form of rise in credit spreads.
The credit risk in corporate bonds is measured by credit spreads.
Calculating Credit Spreads
The following AAA rated corporate bonds were traded in May 2016.
REC (Rural Electrification Corporation) bond maturing in the year 2026 at yield of 8.16%
HDFC bond maturing in the year 2026 at yield of 8.38%.
Corporate bonds in India are traded on an annual yield basis.
The yields at which the corporate bonds are trading are higher than the yield on the corresponding maturity government bonds and this difference is the credit spread. To calculate the credit spreads of the bonds traded we will look at the yields at which benchmark government bonds are trading.
The Benchmark Ten Year Government Bond traded at an yield of 7.42%% in May 2016.
Government bonds are traded on a semiannual basis and we have to annualize the yields to calculate the credit spreads. The formula for annualizing yields is as follows
((1+YTM/2) ^ (2))-1 where YTM is the yield to maturity of the government bond.
(1+.074272/2)^2-1=.0758 or 7.58%
Annualizing the yield of 7.42% on the 7.59% 2026 Government Bond using the formula given above we get an annualized yield of 7.58%.
The Credit Spreads of REC and HDFC bonds are calculated as follows
REC- 8.16% – 7.58% = 0.58% or 58 bps
HDFC- 8.38% – 7.58% = 0.80% or 80 bps
Low credit risk and high credit risk
Example 1: Suppose 10 year G-sec annualized yield is at 8.00% and AAA 10 year corporate bond is trading at 8.70% then corporate bond credit spared is at 70 bps.
Example 2: Suppose 10 year G-sec annualized yield is at 8.00% and BB 10 year corporate bond is trading at 10.70% then corporate bond credit spared is at 270 bps.
In example 1 AAA rated bond is said to have low credit risk whereas BB rated bond has high credit risk.
Credit Spread Curve
Corporate bonds are assigned credit ratings by rating agencies. Credit ratings ranged from the highest safety that is AAA to default category that is D. In between the highest and the lowest ratings there are various ratings from AA to CCC with plus and minus sign attached to each rating to show the strength of the rating.
In the normal course of markets, corporate bonds with the highest ratings trade at lower yields and therefore at lower credit spreads than corporate bonds with lower ratings. However there are times when market perception of credit is either better or worse than the rating assigned to the credit. In such cases credit spreads will be skewed as a higher rated bond could trade at higher spreads than a lower rated bond and vice versa.
In India corporate bonds are traded as per their ratings. In May 2016, the following bonds were traded.
PFC (AAA) five year maturity bond at yield of 8.05%
Sterlite AA+ five year maturity bond at yield of 9.65%.
The difference between five year maturity PFC AAA bond and Sterlite AA+ bond is 147 bps (9.65%-8.05%).
Hence the spread between five year maturity AAA and AA+ benchmark bonds are at 160 bps. Similarly, spreads will tend to widen along the rating curve with lower rated bonds trading at higher spreads than higher rated bond.
Why Is The Credit Spread Curve Important?
The credit spread curve is important to issuers and investors alike. The spread between an AAA rated issuer and an AA rated issuer if high, suggests that risk perception of lower rated issuers is high in the market. High borrowing costs for lower rated issuers will make them put off investments while investors will worry about further downgrades due to rising finance costs.
On the other hand when risk perception is improving investors will prefer to invest in lower rated bonds at higher credit spreads on the expectation that the spread will come down on the back of improved financial strength and on expectation of rating upgrades.
The fact that investors can make higher returns from credit spreads coming down suggest that interest rates will be stable in the economy. However that is usually not the case and interest rate movements can negate gains from credit spread movements unless the interest rate risk is hedged or unless the investor buys into pure credit spreads.
In the example of PFC five year bond and Sterlite five year bond where spread is 160 bps, if the spread narrows by yield of Sterlite bond coming down by 50 bps to 9.35%, while PFC bond yield stays at 8.05%, the holder of Sterlite bond will gain by narrowing of spreads. On the other hand if Sterlite bond yield rises to 9.80% and PFC bond yield stays at 8.05%, the spreads widen to 175 bps and the holder of Sterlite bond will see lower returns due to spread widening.