NotePD Loader
Ideas Post

explain credit spreads

    1. The spread is the difference between two yields.

    The 10-year Treasury note (the most common benchmark for bonds) pays a certain interest rate. A corporate bond might pay 5% more than that. So if the 10-year Treasury is at 3% then the corporate bond would be at 8%. This is a very simplistic explanation but it's good enough for this list.

    2. Why are they higher or lower?

    Corporate bonds are riskier than government bonds because they can go bankrupt and not pay their debts. Government bonds are backed by taxes so there's no default risk. So, higher yields mean higher risks of default.

    3. What causes spreads to widen or narrow?

    In general, when interest rates go up, all other things being equal, then bond yields will also increase (because when you invest $100 in a 10-year bond it will return $110 in ten years if interest rates rise from 2% to 4%). So, in general, rising interest rates increases the perceived riskiness of all bonds and causes spreads to widen. When interest rates fall, all other things being equal, then spreads tend to narrow because lower interest rates make it cheaper for companies to service their debts and makes it more attractive for investors to buy corporate debt rather than government debt (which always has less risk).

    4. How do companies "roll" their debt?

    When a company issues debt (a "bond"), they have to pay back that debt after some period of time (e.g., 10 years). But most companies don't have cash lying around waiting for that day to come. So what they do is issue new debt with a later maturity date (e.g., 15 years) and use that money to pay off the old debt plus some extra money as a "premium". This premium is how they make money on their investment even though they're paying back earlier than they otherwise would have had they not rolled over their debt with new debt with a later maturity date.

    5. Why do companies roll over? Because it saves them money! They save on the premium plus get lower payments later on because interest rates have fallen since the initial issuance of their debt.

    When you buy a house, you usually take out 30 year mortgages instead of 25 year mortgages because you get lower monthly payments if you stretch out your mortgage term beyond 25 years since mortgage payments are determined by dividing the principal by monthly compounding periods (e.g., 25 years equals 52 compounding periods per year while 30 years equals only 26 compounding periods per year). In this case, companies issue new 30 year bonds every time an older issue matures so long as market conditions make such an issuance profitable for them versus just issuing another 10 year bond at whatever current market conditions are at that moment in time (which could be different from what was happening when they initially issued their first 10 year bond).

    6. Why does this matter

    Because credit quality matters
    If quality goes down then spreads go up even if there's no change in economic fundamentals or business prospects
    This is why stocks fall when there's talk about problems with specific high quality stocks like Apple or Disney but stocks don't necessarily fall if there's talk about problems with low quality stocks like semiconductor manufacturers or airlines even if those industries affect our economy far more than tech or media companies do but stock prices don't move much when there's news about problems with low quality tech or media companies because those industries aren't as economically important as airlines and semiconductor manufacturers are (at least right now)
    Quality matters
    And sometimes people forget that when stocks go down despite seemingly good earnings reports coming out of these sectors due to worries about defaults and/or concerns over
0 Like.0 Comment
Comments (0)

No comments.