What Does it Mean When a Company's Corporate Spread Tightens?
To fully understand what it means when a company's corporate spread tightens, we need to know about bonds, bond yields, and bond spreads. Credit or corporate spread is the additional interest rate a lender requires for risk management.
Bonds and Bond Yields
Bonds are an investment option in which you would give your investment to a corporation or even the government for a specified time.
In exchange, you will receive fixed returns, known as coupons, which are determined by the bond’s interest rate. Once the bond duration is completed, the corporation or government repays the invested amount.
Bonds fall in the fixed return investment category as the investment amount gives the investor specific returns throughout the bond’s life. This is what is known as the yield of the bond.
Bond issuers use bonds to generate funds for new projects, business operations, or acquisitions. For example, governments generally issue bonds to raise funds for infrastructure projects, supplementing revenues raised from taxes.
While stocks signify ownership in a company, bonds are units of debt. People holding bonds have technically lent money to the person or business that has issued the bond.
In simple terms, a bond is an IOU, specifying how much reward the IOU holder will get when the money is returned.
This interest rate is usually determined through basis points. Spread is generally decided over the matching government bond yield. The lower the risk, the lower the spread.
Corporate Spreads Explained
Corporate spread is commonly measured in what is known as basis points. These are “hundredths of a percent” over the government bond rate. This means that a spread of 100 basis points is 1% over the government bond rate.
For instance, if a five year Treasury bond trades at a yield of 2% and a five year corporate bond trades at a yield of 6%, the credit spread is 6% – 2% = 4%.
So what does it mean when a company’s corporate spread tightens? A spread in any interest-bearing investment tightens (lowers) with better economic conditions and widens with deteriorating economic conditions.
Corporate spread is the additional interest paid over the interest from relatively risk-free US Treasury bonds (which are the benchmark in a way).
The spread of corporate bonds increases or decreases according to business and economic risk factors.
Credit spreads usually rise when there are selling sentiments in the market. There is excess supply, and risk is higher too.
Spreads fall when the market is recovering, and there is a surge in demand. In short, a tighter spread signifies that buyers are comfortable investing.
They have low fear of any default and lower their risk. When there are wider spreads, the investor is cushioning themselves from the higher risk expectations and taking a higher return.
In the case of a specific company, the company usually issues bonds to finance its operations, capital expenditure, or some other need. Corporate spread is generally based on the additional interest over the US treasury bonds that the investors will expect to invest in the bond.
This additional interest is compensation for the risk the investor is exposed to. Since companies can go out of business and fail to earn profits from their projects or expansion plans, they are risky options for investors.
To attract investors, they have to offer higher rates above the US Treasury bond rates (which are the lowest risk options for investors).
The bond or yield spread is the difference between two separate groups of bonds. Since bonds are time and yield based, they are in different groups and are usually selected for investment based on their profits.
The spread helps determine the yield and valuation of the bond in the secondary market, in particular. In addition, spreads act as a signal for investors about which bonds are riskier, and they help determine the final pricing of the bond for the buyer and seller.
What Makes Spreads Tighten?
A corporate (or credit) spread is the additional interest a lender wants as compensation for the additional risk they incur by investing in the company.
Since yields on bonds are relatively fluid due to market and interest rate fluctuations, the spread on bond yields also fluctuates and can tighten or expand according to market influences.
If a company is experiencing tightening spreads, it means that the risk perception is improving. This is because investors trust the company enough to invest in it for lower spreads. This could be due to strong financial statements, better loan servicing, or overall stable market perception.
With tightening spreads, we can infer that the company is associated with low default expectations and overall low risk. However, tighter spreads also mean that investors will get lower returns on their investments.
This means a company could lose investors or have its bonds face low demand. This will be due to a lack of investor interest just because the returns offered are too low, or they will not be able to generate sufficient interest in the secondary market.
This lack of interest in the primary market means that investors looking for high investment yields will not be excited about investing in the company. Such investors are known as growth or premium investors and are looking to make slightly more risky investments to earn higher profits.
At times, corporate or company spreads tightening occurs because there is an excess supply of investment options, and the US Treasury yields are low. However, this can be risky as such bonds have higher risk ratings than US Treasury bonds.
Conclusion
Bonds are a debt instrument in which companies borrow money from their investors. Bond spreads tighten with better performance and low risk perceptions for companies.
Since the corporate spread is the additional interest paid over the interest from US Treasury bonds, it falls when there are positive and low risk perceptions about the company issuing the bond.
Bonds are also commonly used in a long volatility strategy which you can read about here.
