Spread on Corporate Bonds Explained for Investors

The spread on corporate bonds is a crucial concept for investors to understand. It's the difference between the yield on a corporate bond and the yield on a similar government bond.

This spread can vary depending on the credit rating of the corporate bond issuer. For example, a bond issued by a highly rated company like Johnson & Johnson might have a lower spread than one issued by a lower-rated company like a small startup.

As a result, investors who buy corporate bonds with a higher spread are essentially lending money to the company at a higher interest rate than they would to the government. This higher interest rate compensates for the increased risk of default.

Corporate bonds are debt securities issued by companies to raise capital from investors. They are essentially loans to the company, with the investor receiving regular interest payments and their initial investment back at maturity.

The issuer is responsible for making interest payments to bondholders, typically semi-annually or annually. This can be a fixed rate, such as 5% per annum, or a floating rate tied to a benchmark like LIBOR.

Corporate bonds are often considered a lower-risk investment compared to stocks, as they offer a relatively stable return with a fixed interest rate. This is because the company is obligated to make interest payments and eventually repay the principal amount.

A company may issue bonds to finance a specific project or to refinance existing debt. For example, a company might issue bonds to fund the construction of a new factory or to pay off high-interest loans.

Investors can purchase corporate bonds through a financial institution or a brokerage firm. They can also buy bonds directly from the issuer, although this is less common.

Corporate bond prices can be influenced by various factors, including the financial performance of the issuer, perceived risk in the bond market, and general market conditions.

The price of a high-yield corporate bond, for instance, can fluctuate throughout the trading day based on the financial performance of the issuer and the level of risk perceived in the bond market.

A high-yield corporate bond's price is quoted on a dollar-price basis, which represents the percentage of par value at which the bond trades.

Government bonds are considered safer investments because they have stronger credit ratings and a lower chance of default risk. They are backed by the U.S. government, making them a low-risk option for investors.

The yield on government bonds is typically lower compared to junk bonds, which is why they don't offer as high a return. This is because government bonds are considered risk-free, whereas junk bonds come with a higher risk of default.

If the credit spread between a government bond and a junk bond increases, it indicates a larger difference between the yields of both bonds. This means there's an even bigger risk of investing in the junk bond compared to the government bond.

The difference in yield between a government bond and a junk bond is often referred to as the high-yield bond spread. This spread can be used to determine the riskiness of a junk bond.

Ranges of corporate bond credit spreads can vary significantly, even among bonds with similar credit ratings. For instance, a chart by Bondsavvy shows a range of credit spreads for five corporate bonds, including high yield and investment grade bonds.

The credit spread is the difference in yield between a same-maturity Treasury bond and a corporate bond, and it reflects the additional yield required by an investor for taking on additional credit risk. If the credit spread is 0%, it implies that the corporate bond offers the same yield as the Treasury bond and is risk-free.

The chart by Bondsavvy compares the credit spreads of various corporate bonds to the financials of each bond issuer, helping to assess whether a particular bond is a better value than another. This is particularly useful when bond ratings methodologies are flawed, creating opportunities for "bond-savvy" investors to find bargains.

The credit spreads of the five corporate bonds shown in the chart varied significantly, with Apple bonds having the lowest credit spread due to their high credit quality. The credit spreads also changed over time, with the Federal Reserve's historic interest rate hikes in 2022-2023 having a significant impact on the yields of corporate bonds.

Investing in corporate bonds can be a great way to diversify your portfolio and earn a steady income, but it's essential to understand the current market conditions.

Investment-grade corporate bonds are quoted as a spread to the benchmark Treasury, and this spread can fluctuate based on market conditions and the issuer's financial performance.

The current credit spreads on corporate bonds are near historic lows, driven by companies improving their credit profiles during the post-pandemic period.

Companies have issued new debt, built cash on their balance sheets, and refinanced older issues with higher coupons, which has fortified their balance sheets and enhanced their credit worthiness.

Strong economic growth, robust investor demand, and improved credit worthiness have contributed to spreads at the low end of their historic range.

As of May 23, the credit spread on intermediate maturity IG corporate bonds rested within 15 basis points of its 25-year low relative to US Treasury notes.

Investors may be sensing less risk and asking for less credit spread as compensation, which has led to tighter spreads between higher and lower rated corporates.

Even at these compressed spread levels, corporate debt still offers significant value, with an effective yield of 5.4% in April 2024 that is 80 bps higher than duration matched Treasury securities.

Economic fundamentals continue to support corporate valuations, with a recent Bloomberg survey suggesting 2.4% GDP growth in 2024 and solid earnings growth at IG companies remaining at 7.5%.

Investment-grade corporate bonds are the bread and butter of many investors, and they're rated Baa3 / BBB- and higher by Moody's and S&P, respectively.

These bonds are quoted on a dollar-price basis for individual investors, but when large broker-dealers and money managers trade, they're quoted as a credit spread.

Investment-grade corporate bonds are sensitive to changes in underlying Treasury yields, which can impact their YTM.

The credit spread quote for these bonds is based on their YTM and can range from 2.73% to 2.77% or 273 to 277 basis points.

As a result, investment-grade bonds can be a bit tricky to navigate, especially for individual investors who are used to seeing them quoted on a dollar-price basis.

Calculating corporate bond performance is a crucial aspect of understanding the spread on corporate bonds. Spreads fluctuate according to the market’s perception of default and downgrade risks, typically widening during recessions and narrowing during good economic times.

The excess return on a corporate bond is its relative performance compared to the return of a benchmark, which is typically a comparable duration Treasury security. A corporate bond generally produces a positive excess return over the benchmark Treasury security that is roughly equal to the credit spread at the start of the period.

Changes in the Treasury base rate move both corporate and Treasury prices higher and lower together, but changes in the credit spread will push corporate prices higher or lower relative to Treasurys. This is important to understand, as it affects how we calculate a bond's excess return.

A bond’s starting spread and the change in its spread over the period determine its excess return. The wider the credit spread, the greater the protection offered, and the narrower the spread, the less protection offered.

Corporate bonds carry default and downgrade risk, which is compensated by a yield greater than the yield on a similar maturity Treasury, known as the credit spread.

The credit spread fluctuates according to the market's perception of these risks, typically widening during recessions and narrowing during good economic times.

Excess return is the relative performance achieved by investing in a security compared to the return of a benchmark, and can be either positive or negative.

A corporate bond generally produces a positive excess return over the benchmark Treasury security that is roughly equal to the credit spread at the start of the period.

Changes in the Treasury base rate move both corporate and Treasury prices higher and lower together, but changes in the credit spread will push corporate prices higher or lower relative to Treasuries.

A bond's starting spread and the change in its spread over the period determine its excess return.

The yield on Treasuries reflects the risk-free rate, while the credit spread can be interpreted as the incremental compensation earned in excess of the "hurdle rate" by a bondholder.

The core objective of tracking credit spreads in the bond market is to evaluate the risk-return profile of the corporate issuer.

Here are the key relationships between credit spreads and bond yields:

A widening credit spread indicates that lenders must be compensated for the additional risk undertaken, while a narrowing credit spread indicates that investors are optimistic about the near-term performance of borrowers.

The Wall Street Journal presents corporate debt tables in a way that can be a bit tricky to decipher at first, but once you understand the layout, it's actually quite straightforward. The "Current" column shows the credit spread, in basis points, of each corporate bond in the table.

The credit spread is the difference between the corporate bond's yield and the benchmark US Treasury bond yield. For example, if a bond has a credit spread of 273 basis points, as seen in Figure 3, that's what you'd see under the "Current" column.

If the credit spread tightens, the bond price increases, and if it widens, the bond price falls. This is because a tighter credit spread means the corporate bond's yield is closer to the benchmark US Treasury bond yield.

The ICE BofA 1–10 Year US Index has a long history of outperforming Treasury securities. Since December 1996, this index has outperformed similar duration Treasury notes by 0.9% on an annual basis.

This outperformance is not surprising, given the higher yield of investment-grade corporate bonds compared to Treasuries. IG corporate bonds tend to outperform Treasury securities over most time periods.

The index also benefits from rebalancing at a wider spread level, similar to the reinvestment mechanics of a corporate ladder. This allowed the ICE BofA 1–10 Year US Index to outperform Treasury securities by 1.06% from June 2021 through April 2024.

Past performance is not indicative of future results, but it's worth noting that the Fed's stance change in 2021 led to a recovery in credit spreads. The ICE BofA 1–10 Year US Index option-adjusted spread history shows a significant decrease in spreads from 159 bps to 80 bps during this period.

The WSJ Investment Grade Debt Changes table in Figure 4 shows the changes in credit spreads for various corporate bonds.

The table presents the credit spreads in basis points, with a dollar price of 103.135 for Penn National Gaming bonds due in 2027, which increased in price 0.89 points from the previous trading day.

If a bond's credit spread shrinks from the preceding day, it will appear in the "Investment-grade spreads that tightened the most..." part of the table.

If the credit spread widens, assuming the benchmark US Treasury bond YTM doesn't change, the corporate bond's YTM increases, and the bond price falls.

The WSJ presents the table this way because investment-grade corporate bonds are quoted as a spread to their benchmark US Treasury bond or note.

In the table, you'll see the Penn National Gaming bonds due in 2027 had a dollar price of 103.135 and increased in price 0.89 points from the previous trading day, indicating a tighter credit spread.

The changes in credit spreads in the table are based on overall market conditions, as well as how a particular bond issuer is performing financially and if there is any specific news around a bond issuer.

Investment-grade corporate bonds are sensitive to changes in underlying Treasury yields, which is why their prices move up and down based on movements in the credit spread and the benchmark Treasury bond's YTM.

A high-yield bond, also known as a junk bond, is a type of bond that offers a higher yield to compensate for the higher risk of default.

High-yield bonds have yields that are constantly moving, so the spread between them is always changing. For example, if bond A offers a 7% yield and bond B offers a 10% yield, the spread between them is 3% or 300 basis points.

The spread on bond yields is the difference in yields between multiple high-yield bonds, expressed in basis points or percentage points.

A credit spread is the difference between the yield of a 5-year Treasury note and a 5-year corporate bond with the same maturity. If the Treasury note is trading at a 3% yield and the corporate bond is trading at a 5% yield, the credit spread is 2%.

The credit spread is the difference in returns due to different credit qualities, making it a key concept in understanding the spread on corporate bonds.

High-yield corporate bonds are a type of bond that is not primarily impacted by falling or rising interest rates. This is because the credit spread makes up the lion's share of the corporate bond's yield.

For example, the Albertsons 7.45% 8/1/29 bonds had an offer-side YTM of 7.15% and a credit spread of 6.63% on April 24, 2020. The benchmark Treasury YTM was 0.52%, so the credit spread comprised 93% of the bond's YTM.

High-yield corporate bonds are quoted on a dollar-price basis, which represents the percentage of par value at which the bond trades. This means that the price of the bond will fluctuate based on the financial performance of the bond issuer and general market conditions.

A high-yield bond spread can indicate a weakening of the macroeconomic environment and a worsening of the credit quality offered by the junk bonds. This is because a larger spread between two bonds implies a higher default risk in junk bonds.

High-yield corporate bonds can be used to assess the credit markets and evaluate the state of the economy. By understanding how much additional yield investors can get from a particular bond, they can make informed investment decisions.