Credit spreads, also known as Treasury spreads, are the difference between a corporate bond's yield to maturity ("YTM") and the YTM of a US Treasury bond
or note with a similar maturity date (the 'benchmark Treasury'). The credit spread represents the extra compensation, or yield, a corporate bondholder
receives above the so-called risk-free rate of the US Treasury bond. (We don't believe a government that runs trillions in red ink is "risk free,"
but that's a discussion for a different day.) Since corporate bonds are deemed to have a higher default risk than the US government, corporate
bond YTMs are higher than Treasury bond YTMs for bonds of similar maturities. The amount of this difference is the credit spread.
As we discuss in this post, movements in Treasury bond yields and credit spreads will impact corporate bonds in different ways. Treasury yields and credit spreads are the building blocks to a corporate bond's YTM and understanding how their movements impact corporate bond prices is essential knowledge for all corporate bond investors.
How Credit Spreads Work
The best way to show how credit spreads work is through an example of a corporate bond BondSavvy previously recommended and has subsequently sold after the bond price increased 25 points. The recommendation was for Tiffany bonds 4.900% '44 (CUSIP 886546AD2). We recommended the Tiffany '44 bonds on September 5, 2019 at an offer price of 103.01 and a YTM of 4.70%.
In Figure 1, we show the Tiffany bonds' YTM has two components: 1) the benchmark Treasury YTM, shown in blue and 2) the credit spread, shown in orange. The 'benchmark Treasury YTM' is the YTM of a Treasury bond that has a similar maturity date to the Tiffany bonds' maturity date. Since the maturity date of the Tiffany bonds is October 1, 2044, the benchmark Treasury is the US Treasury 3.00% 11/15/44 bond (CUSIP 912810RJ9). The reason the benchmark Treasury has a similar maturity date to the corporate bond we are evaluating is that we want to isolate what part of the corporate bond's yield is moving due to movements in US Treasury yields vs. the portion of the yield that is changing based on the credit-risk component of the bond. If we selected a Treasury bond with a maturity date in 2025 instead of 2044, there would be differences in the benchmark bonds' maturity dates, which would impact the YTMs of both bonds. By referencing the corporate bond against a Treasury bond with a similar maturity, we can identify the portion of the YTM that is the credit spread.
On September 5, 2019, the US Treasury '44 bond had a YTM of 1.99%. Since the Tiffany bonds had a YTM of 4.70%, the credit spread was 2.71% or, 271 basis points. For bond newbies, 100 basis points (or 'bps') equals 1 full percentage point. Fifty bps equals 0.50%.
Figure 1: YTM Building Blocks: Tiffany 4.900% 10/1/44 Bond
Prices and yields sourced from Fidelity.com
Since the credit spread on the Tiffany bonds was 2.71% on September 5, 2019, if we were to hold the Tiffany bonds until the maturity date, we would receive 2.71 percentage points of additional annual return compared to the US Treasury '44 bond. We receive this extra yield since the Tiffany bonds are deemed to have a higher risk of default than the US Treasury bonds. Bonds with a low -- or narrow -- credit spread are generally deemed to have a higher credit quality and less default risk than bonds with a higher -- or wider -- credit spread.
What causes bond price changes?
In Figure 1, the YTM of the Tiffany bonds was 4.70% on September 5, 2019. This corporate bond YTM will move up and down based on movements in the credit spread and the benchmark Treasury yield. Assuming no change in the US benchmark Treasury YTM, if the credit spread increases, the Tiffany bonds' YTM will increase, which will cause the bond price to fall. Should the credit spread shrink, the bond's YTM will also shrink causing the bond price to increase. The same dynamic happens if the credit spread goes unchanged and the benchmark Treasury yield increases or decreases.
The reason why the Tiffany bonds increased in price from 103.10 to 128.00 over the course of 4 1/2 months is there was a sharp decline in the Tiffany bonds' credit spread. This credit spread decline was driven, in large part, by LVMH and Tiffany entering into an agreement on November 25, 2019 where LVMH was going to acquire Tiffany. Many investors believed the combined LVMH-Tiffany would be of a higher credit quality than Tiffany standalone and, on November 26, 2019, S&P put Tiffany's bond ratings on 'CreditWatch Positive,' since Tiffany (rated BBB+ by S&P) was being acquired by a higher-rated entity in LVMH, which was rated A+. LVMH would assume the Tiffany debt as part of the transaction and, generally speaking, when a higher-credit-quality company acquires a lower-credit-quality company, the bonds of the lower-rated company should move up in ratings to match the acquiring company's bond ratings, provided the acquisition doesn't materially worsen the acquiring company's credit profile.
As the Tiffany bonds' credit spread fell from 2.71% to 0.96%, the bonds' YTM fell to 3.20% and the bond price increased to 128.00. At the time, this credit spread was in spitting distance of certain Apple bonds. Since Apple has a far superior credit quality than Tiffany (Apple's $200+ billion in cash has a big impact on that), we didn't believe the Tiffany bonds' credit spread could fall much further and, as a result, we decided to sell the Tiffany bonds at 128.00 and achieve a 26% total return. Please read the full blog post of our Tiffany bonds investment and view our investment returns from our current and previous corporate bond recommendations.
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While the Tiffany bonds' credit spread shrunk significantly, the benchmark Treasury bond YTM increased 0.25 percentage points. This was a moot point, however, since the credit spread decreased by such a larger amount than the Treasury bond YTM increased, which is why the bond price increased 25 points.
Many investors might be surprised that a corporate bond's price could increase 25 points over the course of four and one-half months. The reason this could happen is that the Tiffany bonds weren't due until 2044 and bonds with a longer time to maturity can be far more volatile than corporate bonds that mature in the near term. This can also work in the investor's disadvantage, as a long-term corporate bond can also fall significantly in price. For example, in the midst of the COVID-19 crisis, the Apple 4.650% 2/23/46 bond (CUSIP 037833BX7) fell from 140 to 104 over the course of several days due to redemption-fueled forced selling by bond funds. A shorter-term Apple bond, Apple 3.45% 5/6/24 (CUSIP 037833AS9), only fell eight points, from 108 to par. Given Apple's strong credit quality and the market boost engineered by the US Treasury and Federal Reserve, in mid-2020, both bonds were trading at levels similar to where they traded before COVID-19.
Ranges of Credit Spreads for Corporate Bonds
When BondSavvy makes corporate bond recommendations, we compare the credit spreads of various corporate bonds to the financials of each bond issuer. This helps us assess whether a particular bond is a better value than another. The flawed bond ratings methodologies of Moody's and S&P create many opportunities where bonds are misrated and, as a result, certain corporate bond credit spreads can be inflated relative to their issuing company's financials. This can create bargains for 'bond-savvy' investors.
Figure 2 shows a range of credit spreads and the benchmark Treasury bond YTM for five corporate bonds:
1) Ford Motor 4.75% '43 (CUSIP 345370CQ1)
2) Kroger 4.50% '29 (CUSIP 501044DL2)
3) Kroger 3.875% '46 (CUSIP 501044DF5)
4) Apple 4.45% '44 (CUSIP 037833AT7)
5) Albertsons 7.45% '29 (CUSIP 013104AF1)
The reason we show Figure 2 is so bond investors can see the range of corporate bond credit spreads. When we created this chart, Apple had the highest credit quality of all of the bond issuers shown and, as a result, the Apple bonds 4.45% '44 had the lowest credit spread. Kroger is also a very strong credit, but it's not as strong as Apple. Ford had been impacted negatively by the COVID-19 crisis, and its credit spread has increased from 3.04% on January 22, 2020 to 6.53% on April 24, 2020.
The other dynamic this chart shows is how the maturity date of a bond impacts a corporate bond credit spread. While the Apple '44 bond has a credit spread that is 73 basis points (or 0.73 percentage points) narrower than the Kroger '46 bond, it's only 23 basis points narrower than the Kroger '29 bond. The reason for this is that, all else equal, credit spreads are narrower for shorter-dated bonds since there is a lower risk of default over the near term than there is, in say, 25 years.
Since we typically believe in selling bonds prior to maturity to maximize investment returns, we will often recommend a longer-dated bond of higher-credit-quality corporate bond issuers, as their credit spread -- and YTMs -- are higher than shorter-dated bonds and offer significantly larger opportunities for capital appreciation and higher total returns.
Figure 2: Corporate Bond Credit Spreads and YTMs - April 24, 2020
The Albertsons '29 bond is a case of a bond that has been forever unloved by bond rating agencies. The company's leverage ratio recently fell below 3x, which is typically good enough to obtain an investment-grade bond rating. Unfortunately, the bond rating agencies have never gotten it right with Albertsons. Moody's withdrew its bond rating several years ago, and S&P rates it B+. S&P rated the bond CCC+ as late as June 27, 2019 even though Albertsons continued to report strong operating performance and a significantly reduced debt load. Albertsons is a perfect example of where we found a bond issued by a strong company that was trading with a credit spread far higher than it should be. We recommended the Albertsons bonds at a price of 78 on September 26, 2017 and, in late 2020, the bonds were trading between 115.00 and 119.00.
Credit Spreads and Investment-Grade Corporate Bonds
As we show in our bond ratings scale post, bonds rated Baa3 / BBB- and higher by Moody's and S&P, respectively, are deemed investment-grade corporate bonds. Bond ratings have many weaknesses, such as flawed bond rating methodologies and not factoring in a bond's price, yield, maturity date, interest-rate risk, liquidity, and relative value. That said, they do have a significant impact on how bonds trade and their level of duration risk, or how sensitive corporate bonds are to rising interest rates. This impact is driven by how corporate bonds are quoted on brokerage and institutional money manager trading desks.
While individual investors will always see bonds quoted on a dollar-price basis (shown in the orange box in Figure 3), when large broker-dealers and money managers trade large blocks of investment-grade corporate bonds, the bonds are quoted as a credit spread. As shown in Figure 3, the top-of-book bid-offer quotes on this eBay '42 bond were 3.96% / 3.91% on a YTM basis. As shown in the large blue box below, these corporate bond YTMs imply a credit spread quote of 2.77% / 2.73% or, if presented in basis points, 277 / 273. These credit spreads will go up and down 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, such as a large acquisition.
Since investment-grade corporate bonds are quoted as a spread to the benchmark Treasury, the corporate bond YTM will move up and down based on movements in the credit spread and in the benchmark Treasury bond's YTM. This is why investment-grade bonds can be sensitive to changes in underlying Treasury yields. In addition, since investment-grade corporate bonds are issued with longer-dated maturities and lower coupons, their duration risk is materially higher than that of high-yield corporate bonds.
Figure 3: Corporate Bond Price Quotes -- eBay 4.00% 7/15/42 (CUSIP 278642AF0)
Source: Quotes shown on Fidelity.com April 27, 2020
Credit Spreads and High-Yield Corporate Bonds
Corporate bonds rated below investment grade (also known as 'high-yield bonds') are generally not impacted by falling or rising interest rates. There are two primary reasons for this. First, when high-yield corporate bonds are quoted on a trading desk, they are quoted on a dollar-price basis, which represents the percentage of par value at which the bond trades. For example, in Figure 3, the eBay bonds are quoted at 100.54 / 101.35 on a dollar-price basis. This means you could purchase one eBay '42 bond for $1,013.48 or sell one eBay '42 bond for $1,005.42. The price of this bond will move up and down due to changes in the underlying credit quality and performance of the bond's issuer, as well as general market conditions. This is different than an investment-grade corporate bond, which is quoted as a spread to the benchmark Treasury and can be heavily impacted by changes in Treasury yields.
Second, while all corporate bond YTMs are composed of the credit spread and the benchmark YTM, for high-yield bonds, the credit spread generally makes up the lion's share of the corporate bond's yield. For example, as shown in Figure 2, 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. Since the credit spread represents nearly all of the bond's YTM, it's clearly the driver of how the Albertsons' YTM will move up or down and, in turn, the price of the Albertsons bonds.
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You Can Now Read the Wall Street Journal Bond Tables
Our Founder Steve Shaw has presented to over 20 American Association of Individual Investors (AAII) chapters nationwide. Following one presentation, an attendee asked how to read the corporate debt tables shown in the Wall Street Journal. After reading this blog post, you will now have a full understanding of why the WSJ corporate debt tables are presented the way they are and how to read them. Please note that Figures 4 and 5 represent prices from early 2019, when this particular AAII presentation was made.
As shown in Figure 4, the figures under the column "Current" represent the credit spread, in basis points, of each of the corporate bonds in the table. You'll remember, in Figure 3, the eBay bonds had an offer-side credit spread of 273 basis points. If the eBay bonds were to make it into this table, that 273 number is what you would see under the "Current" column. If the credit spread shrunk from the preceding day, the bond would appear in the "Investment-grade spreads that tightened the most..." part of the table. If the credit spread tightened, assuming the benchmark US Treasury bond YTM didn't change, the price of the bond increased, as the corporate bond's YTM would have decreased. On the other hand, if the credit spread widened, all else equal, the corporate bond's YTM increased and the bond price fell.
The WSJ presents the table this way since investment-grade corporate bonds are quoted as a spread to their benchmark US Treasury bond or note, as previously discussed.
Figure 4: Wall Street Journal Corporate Debt Table - Investment Grade Corporate Bonds
Since high-yield corporate bonds are quoted as a percentage of their face value, or on a 'dollar-price basis,' the WSJ bond tables show high-yield corporate bonds in the same way. In this 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.
Figure 5: Wall Street Journal Corporate Debt Table - High-Yield Corporate Bonds
The reason we wrote this post was to provide bond investors an understanding of why corporate bond prices move and how credit spreads and US Treasury bond yields impact corporate bonds. Corporate bonds are not a monolithic asset class where every bond is impacted by similar factors. Many investors believe it's 'interest rate policy,' which drives bond markets, but such policies, such as the setting of the fed funds rate, can often have limited direct impact on large amounts of corporate bonds. For example, when the fed funds rate was cut one percentage point on March 15, 2020, the YTM on the 30-year US Treasury bond increased from 1.56% on March 13, 2020 to 1.78% on March 19, 2020. This period of time was marked by extreme bond price volatility and huge increases in credit spreads, which led to sharp decreases in many corporate bonds. Many of these corporate bond prices quickly recovered, but it's crucial for bond investors to understand what causes corporate bond prices to move so they can make better-informed buy and sell investment decisions.