There are many instruments on the financial market investment houses use to predict the future, describe the present and, of course, make money. Today I would like to emphasize credit spreads and what all this is all about.
What are credit spreads?
Let us start by saying that credit spreads are the difference between corporate and government yields with similar maturities but different credit ratings. Put it simply, it is a measure of the risk premium companies pay investors to compensate them for a number of risks associated with corporate debt.
Bond investors usually ask for a positive risk premium to hedge against forthcoming unexpected adverse macroeconomic fluctuations. If the credit spread between a Treasury note or bond and a corporate bond were 0%, it would imply that the corporate bond offers the same yield as the Treasury bond and is risk-free. The higher the spread, the riskier the corporate bond.
Credit spreads and Treasury rates
Curiously, the relation between credit spreads and Treasury rates depends on the time horizon. Over the short-run, credit spreads are negatively related to Treasury rates. Initially, spreads narrow because a given rise in Treasuries produces a proportionally smaller rise in corporate rates. Over the long term, on the other hand, this relation is reversed. A rise in Treasure rates produces a larger rise in corporate rates.
Growth expectation effect
On the other hand, it reflects investors’ expectations about the future strength of the economy. Historically, credit spreads tend to peak at the end of recessionary periods and recover along with growing government bond yields.
In other words, bond markets expect higher real growth rates, inflationary pressures, and a consecutive change in monetary policy. It means they have a negative correlation: economic recovery is normally followed by improving credit metrics because of increasing cash flow generation.
Rising inflation expectations, which push yields higher, also mean better pricing power prospects for companies, and initial rate hikes by central banks usually tend not to negatively affect equities and corporate bonds. Furthermore, spreads offer a cushion to the negative duration effects arising from an increase in bond yields.
Credit spreads during Covid-19
For example, during the Covid-19 crisis, credit spreads increased by about 300 basis points but quickly started to revert to the trend. One of the possible reasons could be explained by policy actions. During the COVID-19 pandemic, the Fed responded swiftly by announcing the Primary and Secondary Market Corporate Credit Facilities on March 23, 2020, just three weeks after the onset of the crisis. At this point, credit spreads quickly started to revert to pre-crisis levels.
Additionally, the company’s asset value and its volatility as well as the leverage ratio of a firm should determine the credit risk of a corporate bond. When implied volatility decreases, credit spreads narrow, and vice versa. Another factor that provides support for tighter credit spreads is the strong earnings growth which has seen profitability rising to repeated highs across all major markets.
According to research conducted by Amundi, over the past 50 years, recessionary phases were followed by a substantial rise in bond yields, thus credit rallies. Furthermore, postrecession credit rallies are more vigorous and run out of steam sooner when bond yields rise sharply, as occurred in the 1980s and 1994.
At the same time, credit spreads indicate a probability of default of corporate issuers. Thus, central banks use it as an indicator that something is not going right and it’s time to interfere. Normally it means that massive asset purchases or QE programs.
One more relationship we need to keep in mind is between retail flows and returns of credit products. First thing first, it should be mentioned that returns and flows tend to go hand in hand: sudden and sharp upward trends in rates, affecting credit returns, tended to trigger subsequent outflows.
Now, we can move to credit spread as a financial instrument.
As it couldn’t be another way, there is a way to bet with credit spread – through options. There are two types of Credit Spread Option strategy:
- 1. Bullish Credit Spread – this strategy implies selling PUTs of a particular strike price of the financial asset and buying PUTs (of equal numbers) of the lesser strike price.
Net Premium Received = Premium Received while Selling PUT (of Strike X1) – Premium Paid while Buying PUT (of Strike X2) - Bearish Credit Spread – involves selling CALLs of a particular strike price of the financial asset and buying CALLs (of equal numbers) of the greater strike price.
Net Premium Received = Premium Received while Selling CALL (of Strike X1) – Premium Paid while Buying CALL (of Strike X2)
Pros and cons of credit spread options:
On the positive side, I find it important to say that this strategy is used to hedge and limit the loss to a certain pre-defined quantity, which can be calculated before the strategy is entered. Return on capital blocked as the margin is higher compared to naked option selling (as being spread strategy lesser margin is blocked). Also, when you create them you will receive cash upfront into your trading account.
Its advantage is at the same disadvantage as the maximum profit is limited, and it is obtained right at the time of deployment. The risk/reward ratio is skewed in favor of risk.