The relationship between interest rates and credit spreads

Interest rates and credit spreads

Interest rates for different types of bonds normally don’t change by the same degree together. When there’s a lot of uncertainty in the market, investors tend to park their money in super-safe U.S. Treasuries, causing their yields to drop and prices to rise. On the other hand, in times of uncertainty, investors expect higher returns from high-yield bonds to compensate for the increased risk, causing their yields to rise and the prices to drop. So even though Treasury yields are falling, the credit spread for high-yield bonds is getting wider.

Accordingly, examining credit spreads gives investors an idea of how cheap (a wide credit spread) or expensive (a narrow credit spread) the market for a particular bond category or a particular bond is.

Credit spreads as an economic indicator

Credit spreads also give investors an idea as to where the economy is heading.

Improved economic conditions are signaled by improvements in company profitability and lower corporate default rates. This causes investors to view investment-grade and high-yield corporate bonds more favorably, which causes the credit spread to contract. Moreover, improvement in the economy prompts the Fed to hike interest rates in order to ward off inflationary pressure. This increase in interest rates causes Treasury yields to spike, in turn tightening credit spreads.

The reverse happens in the case of an economic slowdown.

Market behavior

Bond investors try to anticipate changes in the fundamentals of the economy and the individual bond issuers they follow. Because of this trend, credit spreads often move ahead of the economy, offering the intelligent investor some predictive power they can use to profit and avoid losses.

Changes in interest rates affect investor behavior to a great extent. Certain exchange-traded funds (or ETFs) like the ProShares Investment Grade-Interest Rate Hedged ETF (IGHG), which has its major holdings in companies like Citigroup Inc. (C) and JP Morgan Chase & Co. (JPM), the Vanguard Short Term Corporate Debt ETF (VCSH), and the PowerShares Senior Loan Fund (BKLN) are designed to protect the investors against interest rate risk caused by inflation.

To see how credit spreads change over time, read on to the next part of this series.