Do Tightening Credit Spreads Add to the Price Gain?
Price Gains and Lower Volatility
Investors may benefit from tighter spreads through an increase in the value of outstanding bonds, all else equal. A potentially more predictable and less volatile stream of future returns due to the lower risk of default are additional benefits. Overall yields decrease, reflecting the reduced risk on the bonds.
Conversely, wider spreads may result in a decrease in value on bonds outstanding, but also an increase in yields to compensate for the perceived credit risk. Although further downgrades do not appear likely in the near term for Turkey, deteriorating credit quality, in the worst case scenario, can eventually lead to default, in which case a loss may be realized despite high spread levels. More typically, a country may take steps to stabilize or improve its credit profile. Other emerging markets sovereign fallen angels1, including Russia and Brazil, experienced large price gains after being downgraded to non-investment grade as their credit spreads tightened significantly, more than making up for losses experienced prior to the downgrades.
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Market Realist – Credit upgrades are boosting the Hungarian bond market
Hungary’s credit upgrades to “investment-grade” (FLTR) opened doors for investors tracking low-risk benchmarks. The upgrades not only reduced the borrowing cost for Hungarian bonds but also resulted in strong demand for Hungarian bonds during its latest bond auctions. The situation was further aided by improved liquidity in the banking sector due to monetary policy easing. Since mid-September, foreign investors increased their allocation in local bonds. The situation improved after Moody’s followed suit by upgrading Hungary’s sovereign rating on November 4, 2016. These series of upgrades could pave the way for a return to international markets for Hungary amid current yield levels.
Going forward, the ECB’s dovish stance, as well as the country’s improved economic numbers could provide room for lower yields. Further, recent rating upgrades should prompt lower yields on the longer end of the curve.
- Fallen Angel refers to bonds that were rated investment grade at the time of issuance but were subsequently downgraded to non-investment grade. ↩