On July 18, 2013, the City of Detroit filed for bankruptcy. This gives Detroit the dubious honor of being the largest US city ever to file for bankruptcy. Before the city’s bankruptcy filing, bonds tied to Detroit’s retirement obligations were trading at 38.5 cents on the dollar. By the following day, those bonds had fallen another 1.5 cents. Even general obligation bonds, which are backed by the city’s tax powers and usually considered among the safest municipal bonds, were trading at less than 90 cents on the dollar. The risk of default is looming but Detroit bonds experienced consistent credit rating downgrades in recent years. This downward trend indicates significant credit risk. While these events clearly demonstrate the loss potential that is inherent in credit risk, investors should ask: “Are lower quality bonds worth the risk?”
Higher Risk Requires Higher Return
Most bond investors focus on interest rate levels and risk as the key drivers of fixed income returns. This is accurate for a certain segment of the bond market. Typically, when interest rate levels are referenced, this applies only to “risk-free” investments, such as very short-term US treasuries. However, many of the bonds available today are not risk-free and require a higher interest rate payment to bondholders. Logically, this makes sense. Why would investors purchase risky bonds for the same interest payment as US treasuries?
Higher risk bonds pay higher interest rates to compensate investors for that risk. This increased interest rate over the yield paid by risk-free investments is referred to as a spread. These types of bonds are often categorized as “spread products.” These spreads are demanded by investors based on varying types of risk inherent in those bond investments. Risk is available in many flavors within the fixed income market, but credit risk is among the most common and creates a credit spread.
What is Credit Risk?
Technically, credit risk contains two distinct components. The first is the risk of default, which is that the bond issuer may run into financial challenges that lead to an inability to repay debt holders. The second is spread risk, which is the potential loss in value of a bond due to adverse changes in credit quality as well as credit rating downgrades. These two risk factors cause uncertainty in the total return figures. Obviously, an increased interest payment is desirable as an investor, especially in a low interest rate environment. However, it is critical to understand how the increased risk may affect the risk profile of a fully diversified portfolio. In the case of failing bond issuers, credit risk can be substantial and a serious threat to investors.
The quality of that credit risk is evaluated by ratings firms, such as Standard & Poor’s, Moody’s, or Fitch, which assign each bond issue a rating that corresponds to the risk assumed by purchasers. US treasury bonds are assigned high-quality ratings (AAA, Aaa, etc.). Higher risk bonds are assigned lower ratings (C, Ca, etc.). At the time of issuance, higher risk bond issues must offer higher interest rates than lower risk issues. The practice of offering higher interest rates as compensation for increased risk is necessary to entice enough purchasers to sell the entire bond issue. The credit spread for an issue may increase or decrease as its credit rating is upgraded or downgraded over time.
A Historical Look at Credit Spreads
Historically, credit spreads for higher quality bonds have hovered around 1% to 2%. When calculating credit spreads, it is important to remove the effects of outside factors causing variations in yield. Maturity is a key example of this. When calculating the credit spread for a particular bond, it is important to remove the yield of a comparable treasury bond in terms of maturity from the yield of the corporate bond. Otherwise, this would skew the resulting credit spread because a portion of that spread would be due to the maturity differences between the two bonds. As an illustration of this concept, the chart below summarizes this information for high quality corporate bonds across several maturity ranges dating back to 1990. Although multiple maturities are displayed, the effects of the differing maturities have been removed from the spread calculation. Therefore, the credit spreads across all four groups of bonds are very similar. Conversely, depending on the risk of the particular bond, the credit spread could be much higher. Junk or high-yield bonds, will have significantly larger spreads because of the increased risk.
How does Spread Risk affect bond prices?
Spread risk is often overlooked by investors because it is lumped in with interest rate risk. This is because mechanically, spread risk often has a similar effect as interest rate risk. As discussed, spreads are essentially an “add-on” to the interest rate being paid by the bond. Therefore, if spreads increase, this reflects an increase in the total interest rate required by corporate bonds. Let’s return to our comparison of corporate and treasury bonds as an example and, specifically, the spread changes between September 1998 and July 2000. Both of these yield components increased during this time which caused corporate bond yields to increase from just under 6% to roughly 7.5%. Therefore, comparable bonds issued at a 6% rate in 1998 were paying 7.5% in 2000. So, what happens to the price of those 6% bonds when there are other higher yielding options for investors? It falls. This is similar to how rising interest rates negatively affect current bond prices.
However, this assumes that spreads and interest rates are moving in the same direction. This can be a dangerous assumption because of the low correlation between these factors. More often than not, spreads and treasury yields move in opposite directions. An extreme example occurred between June 2006 and December 2008, when treasury yields plummeted by more than 3% while credit spreads spiked by more than 4%. All the attention was turned toward the equity markets because of the record declines, but this was a significant event for bonds as well. The net effect was record treasury performance (because rates fell) and falling corporate bond prices. This is the key – although treasury yields fell, spreads increased by a greater margin. Therefore, the total yield for corporate bonds actually increased (causing a price decrease). The chart below summarizes the treasury yield and credit spread changes over this time.
How is Credit Risk valuable to investors?
The spike in spreads during the 2008 recession brings to light an important characteristic of credit spreads. Particularly, credit spreads are extremely sensitive to general equity market risk. During times of heightened risk, credit risk is elevated and credit spreads increase. This is because during these times, the chances are higher for a bond default or rating downgrade. When times are good, these risks are less of a concern to investors.
On the surface, this may appear to be a negative characteristic of bonds with credit risk. However, the silver lining is that credit spreads are not correlated with interest rates – spreads are affected by differing factors compared to the interest rate environment. This means that they can move in opposite directions having opposing and often unpredictable impacts on bond prices. The correlation between treasury yields and credit spreads is approximately -0.5, which indicates an inverse relationship. In fact, credit spreads show a higher correlation to the S&P 500. The chart below returns to our previous comparison of treasuries and corporate bonds. This chart displays the historical average yields of a range of treasury securities carrying a 2- to 30-year maturity, along with the corresponding credit spreads for high quality corporate bonds of the same maturities.
Many investors rely on fixed income securities, especially those with conservative risk tolerances. In times of low interest rates and elevated interest rate risk, bonds with credit risk can be a useful tool to help mitigate these concerns. In a sense, investors have the opportunity to swap a portion of their interest rate risk for credit risk, ultimately decreasing a bond portfolio’s total interest rate risk. This tradeoff may not make sense in every environment or for every investor. However, bonds that contain credit risk present another option for income generation and risk management, as opposed to relying solely on very interest rate sensitive bonds.
Conclusion
Detroit’s deteriorating financial condition has led many bondholders to focus only on the negative implications of credit risk. Credit risk includes the risk of credit rating downgrade as well as default, but typically offers attractive yields to investors. As credit spreads adjust over time, they tend to move differently than the broad interest rate environment. This offers bond investors a unique opportunity to diversify away from their dependency on interest rates and offers additional flexibility when managing portfolio risk.
Written by: Steve Osterink, Jr. CFA®, CFP®, AIF®
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Steve Osterink, Jr. offers Investment advisory services through Advisory Alpha, LLC an SEC-registered investment advisor and AlphaStar Capital Management and SEC-registered investment advisor. CFA® is a trademark owned by the CFA Institute. Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™ and federally registered CFP (with flame design) in the U.S., which it awards to individuals who successfully complete CFP board’s initial and ongoing certification requirements.
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