what is quality spread? There is an example in LOS 66j , that explains the stock return using multifactor model.It says, apart from other things, that a decrease in quality spread is good news for stock MT. I looked up the meaning of quality spread ( Credit spread) but am confused as to how does reduction in quality spread is a good news for a stock and vice versa. Can someone please help me with an example here? Thanks
you need to pay less of a spread (difference in rates) for the quality difference between this stock and some other stock. Less Spread is usually better. rate at which you discount the cash flows is affected by the spreads… so if a lower spread is attached to a stock - it will be discounted at a lower rate - and when that happens - value goes up.
Decreasing quality spreads sounds like a bad thing, but it is actually a good thing for the company you are valuing. The quality (credit) spread decreasing tells you corporate yields are going down from investors bidding up corporate bonds. and comparable government yields are increasing and treasury prices falling due to investors moving money into riskier assets. Basically investors who would only borrow from a BBB rated corporation for 10 YR at 5% before are now comfortable borrowing at 4%. If you remember from the Bond Yield + Premium approach of equity valuation, you will recall that required return assumptions on an equity can be made by just tacking on equity risk premium to the yield of your corporate bonds. So anytime the quality spread decreases, your bond yield goes down, and required return goes down too as there is less risk. Your discount rate goes down, so your valuation goes up.
Thanks cp and eastCoastJ You both were right on the money for me. thanks a lot
CPK: You’re still with us L2’ers?
nope am in L3 – just keep visiting… earned my visitation rights!
You did indeed…