Investment Banking: How Different Factors Affect Bond Prices - dummies

Investment Banking: How Different Factors Affect Bond Prices

By Matt Krantz, Robert R. Johnson

In investment banking, credit risk on a bond is related to the risk that an issuer may default on interest payments or repayment of the principal. Of course, if a bond defaults, that doesn’t meant that the investor will lose her entire investment in the bond. Investors in bonds that default typically recover some significant portion of their investment. Bonds with higher default risk sell at higher yields to maturity.

Credit spreads are defined as the risk premium over similar-maturity Treasury securities. Credit spreads are a mathematical way to measure how much more yield investors get on one bond than another. Credit spreads are critical for investors to make sure they’re being compensated enough for the extra risk they’re taking on a bond with more potential problems.

For instance, if ten-year Treasury bonds are yielding 3 percent, and a particular corporate issuer is yielding 5 percent, then the credit spread is 2 percent, or 200 basis points. (A basis point is defined as one-hundredth of a percentage point.)

Credit spreads tend to widen during economic downturns as investors become concerned that corporate profits and cash flows will decline and negatively impact the ability of firms to service their debt. During recessions, credit spreads tend to widen on virtually all corporate issues and the prices of bonds decline overall. Conversely, during economic recoveries and booms, credit spreads tend to narrow as investors become more optimistic about firm cash flows.

The combination of these different factors determines the specific yield to maturity for a bond issue. Both economic-wide (macro) and firm-specific (micro) factors affect the yield to maturity on bond issues and, thus, the value of bonds.