Page 15 - FINAL CFA II SLIDES JUNE 2019 DAY 10

LOS 37.g: Explain the determinants of the term
structure of credit spreads and interpret a term READING 37: CREDIT ANALYSIS MODELS
structure of credit spreads.
MODULE 37.6: CREDIT SPREAD
The credit spread curve graphs the relationship between credit spreads (of
bonds with similar characteristics: differences in seniority, first/second lien
provisions, and embedded options distort) and maturity.

It is useful for investors to price a new issue, as well as to determine the relative valuation of an existing issue.

Determinants of Term Structure of Credit Spreads/Curve

1. Credit quality: AAA term structures tend to be flat or slightly upward sloping.
Lower-rated sectors tend to have steeper spread curves, reflecting greater
uncertainty as well as greater sensitivity to the business cycle.

2. Financial conditions: Spreads narrow during economic expansions and widen
during cyclical downturns. During boom times, benchmark yields tend to be
higher while credit spreads tend to be narrower.

3. Market demand and supply: As credit spread includes liquidity premium, less
liquid maturities would show higher spreads (even if the expectations for that
time period are stable). Due to low liquidity in most corporate issues, the credit
curves are most heavily influenced by more heavily traded bonds. Because
newly issued bonds are generally more liquid, when an issuer refinances a near-
dated bond with a longer-term bond, the spread may appear to narrow for the
longer maturity (possibly leading to an inverted credit spread curve).

4. Equity market volatility: Company-value models (structural models discussed
earlier) employ a company’s stock price volatility and balance sheet structure in
Credit spread is inversely related to determining the probability of default. Increases in equity volatility therefore tend
the recovery rate and positively related to widen spreads and influence the shape of the credit spread curve.
to the probability of default.