Corporate Bond Spread is the difference between the yield of a corporate bond and a government bond. Just like we have the government bond yield curve we have a corporate bond yield curve and it tells us the spread at different maturities. (A yield curve is nothing but a graph that shows the yields at different maturities….you have bonds of various maturities – i1 year, 2 year, 10 year etc….if we plot the yields of each bond with the respective yield, we get a yield curve)
Now, the question which comes to mind is what determines the corporate bond spread? I mean suppose we see the difference in yields between one year corporare bond and government bond as 100 bps, can we say it is right? Or if it changes from say 80 bps to 100 bps, what drives the change?
This FRBSF paper explains the concept. First why is it important?
A thorough understanding of the primary factors determining the changes in corporate bond yields is important for proper risk management of corporate bond portfolios. It also is useful to the conduct of monetary policy since developments in the corporate bond market may provide a timely and forward-looking measure of the general business climate as opposed to statistical releases that are inherently backward looking.
The Theory behind the spread:
The logic behind this supposition is that, in a world without distortion from factors such as transactions costs and taxes, the only rationale for credit spreads to exist would be to compensate for the probability of default and the size of the ensuing loss. Thus, the systematic components in corporate bond credit spreads should all be factors that reflect the financialconditions of firms in general.
What about the empirical analysis:
In practice, however, empirical researchers have only been able to explain less than half of the variation in credit spreads, and therein lies the credit spread puzzle.
For example, Duffie, Saita, and Wang (2007) present and estimate a dynamic model for the default probability of 2,770 U.S. industrial firms. They find that, in addition to a set of firm-specific factors, two market-based factors–the 3-month Treasury bill rate and the 12-month trailing return on the S&P 500 index–have significant explanatory power in predicting the default probability of the firms in their sample
Duffee (1998) finds that for most of the rating and maturity combinations considered, a little less than 20% of the variation in the average credit spread can be explained solely by the level and slope of the Treasury yield curve
Collin-Dufresne et al. (2001) study the credit spread changes for 688 different corporate bonds. They control for variables that affect the likelihood of a firm defaulting such as leverage ratio and asset volatility in addition to controlling for the effects of changes in short- and long-term Treasury bond yields and the return on the S&P 500 index. However, they are able to explain only about 25% of the variation in the credit spread changes across the 688 different bonds.
As the spread can’t be explained, the economists term it as a corporate bnd spread puzzle. The paper then looks at two factors that could explain the spread- taxes and liquidity. Read the note for details.
The conclusion is:
The studies reviewed here show that more than half of the variation in corporate bond credit spreads is not related to the financial health of the issuing firm, but rather reflects effects such as compensation for liquidity risk, which can vary over time, and to some extent the tax treatment of corporate bonds.
Thus, using corporate bond spreads to derive conclusions about the general business climate requires a very demanding decomposition of credit spreads into their separate components. Moreover, while the research reviewed here has been able to contribute much to our understanding of the composition of credit spreads on corporate bonds, there are still some significant pieces missing before the credit spread puzzle can be declared solved.