Must-know: Do credit spreads only represent credit risk?

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Mar. 25 2014, Published 4:00 p.m. ET

Credit risk

While credit spreads do give you a good picture of the credit risk of one bond compared to another, it’s not the only factor they represent.

The spread is basically the premium that an investor in a bond expects over a benchmark bond (like a U.S. Treasury) for the additional credit (or default) risk attached to it. However, there are other factors too that go into determining the premium that an investor in a bond demands over a higher-grade benchmark bond. There are several other factors that combine with credit risk to make up the spread premium.

Municipal bonds

Take the case of municipal bonds. Municipal bonds are generally considered risk-free as Treasuries—and they often enjoy favorable tax treatment. This results in most of them actually trading at a yield below the Treasury yield. This means the spread is negative.

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The chart above shows the price performance of the iShares National AMT-Free Muni Bond (MUB), which tracks the performance of the investment grade segment of the U.S. municipal bond market, against the iShares U.S. Treasury Bond (GOVT), which tracks the performance of public obligations of the U.S. Treasury that have a remaining maturity of one year or more.

Corporate bonds

Similarly, many corporate bonds are illiquid, meaning it can be difficult to sell the bond once you’ve bought it because there’s no active market for the bond. Investors will therefore require a higher premium over and above credit risk premium to compensate for the liquidity risk associated with the bond. The premium is known as “liquidity risk premium.” The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) tracks the performance of 600 highly liquid investment grade corporate bonds of companies like Verizon Communications (VZ) and General Electric (GE).

Other factors that affect credit spreads, in addition to credit risk, include the following.

  • The bond’s duration: The higher the duration, the higher the perceived risk, and the higher the spread.
  • Embedded options such as callability: Investors require a premium for accommodating such options, increasing spreads.
  • Event risk (natural disasters, regulatory changes, et cetera): A negative event warrants a higher premium, and consequently a higher spread.
  • Liquidity: As we mentioned, the spread is directly proportional to the illiquidity of the bond.
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