I don’t really know where to put this - (that’s what she said…?) - but I have a quick question regarding spread (HY v.s government bonds). Please don’t move it to an actual CFA forum…
Spreads narrowing = Long bonds & indicative of future economic boom
Spreads widening = short bonds & Indicative of future recession
Can someone please critique these two bullet points? I’ve spent too long looking in the CFA forums for a similar post.
I think I have it backwards right?
it should be that widening spreads are indicative of future expansion no?
The spread is the risk that the company will not be able to pay back their debt. If it increases, that means the likely hood that the company will default will increase, relative to the highly rated stuff. Things are more likely to default in recessions. TSLA is not going to run out of money when the economy is booming and people are going to buy expensive cars (low spread), but will run out of money when people can’t spend 100k on a new car (high spread).
In good times, bad companies won’t really default so the risk premium is lower. Bad companies become risky when the economy isn’t booming.
TSLA was used as a random example – not following their cash flows too closely.
There’s a little bit more to it than that, but hopefully that explains a little bit.
So yeah, if yields are wider, you’re getting paid more in general. Spreads are the proportion of that yield over the risk free rate. So it basically accounts for the risk component. Spreads widen as you go longer duration incrementally (paid more for duration exposure to the credit and uncertainty since you’re further out ) and as you go lower rating spreads widen as well reflecting worse credit risk.
Over time spreads vary and its from a CFA textbook perspective because risk varies. Markets usually operate on a 0-18 month time horizon at best so if spreads are out wider in general, people are assuming the risk has gone up across the market. Narrower, people are feeling good. Spreads are also a factor of risk free rates so people often look at them as ratios, i.e. ratio of A rated spread/yield to treasuries vs ratio of BBB rated or even ratios of one rating to another for relative value. So if risk free rate is zero, you might take a 20 bps spread for BBB but if it’s 5% you probably want like 200 bps (made up numbers).
In reality fundamentals are at best half the picture. Things like QE and overall money flows (does dollar moves effect hedging costs and bring in / stem foreign investors like insurers) dictate prices for any asset class on a short term horizon. So if you have QE out there buying a bunch of high quality structured products and govt debt or even corporate debt in Europe, it pushes down yields for those products which pushes people into higher risk products and actually has ramifications out the whole way through equity as people weigh the risk they need to hit certain total return targets. You also have things like overhang from expected new issuance (pushing secondary markets wider) or lack of issuance (like following cash repatriation) pushing secondary tighter for certain cash heavy names.
In that line, there’s a whole segment of the market (like pensions) that think in absolute return target terms because they buy a bond with the intent to hold to maturity because of tax and accounting implications. So they look at things like 5% yield targets for long term bond attractiveness and buy to that and that creates weird market dynamics that move spreads.
Point is, simply yes, wider yields means more risk in market outlook from a textbook perspective, but it doesn’t always work that way because there’s more to it.
No, risk free rates (especially nominal w/ inflation) going higher means likely expansion as growth outlook and competition for capital builds along with likelihood of fed hikes. But again, there’s things like currency outlook.
It’s kind of circumstantial though. For instance, when rates went to near zero over the past few years, a lot of high yield rates also went down. The reason is that investors didn’t want to lose money, after inflation, by holding money market or Treasuries for near zero yields. So, they bid up the prices of bonds with higher yields. As this has reversed, there could be a rising interest rate environment with also rising credit spreads, as demand for high yield bonds subsides.
So, I don’t think there is a black and white answer. You need to break it into the various variables that affect spreads and see which is more dominant under what circumstances.
This is to my points about how spreads operate as a ration of yields and competition of capital effecting pricing / spreads