PrefBlog

The Bank of Canada released the June 2008 Financial System Review on June 12. One of the three “Highlighted Issues” was Canadian Corporate Investment Grade Spreads.

The authors first define their terms, making a basic point that surprisingly few investors understand:

In general, two important components drive variations in corporate yield spreads. One is the expected loss from default, the other relates to risk premiums. This latter component can be further decomposed into two types: a credit-risk premium and an illiquidity premium. The expected loss from default generally reflects the fundamentals of the firm, such as the degree of leverage and its ability to generate a stable stream of profits. The credit-risk premium is related to the variability of, or uncertainty about, potential loss from default. Both the credit-risk premium and the expected loss from default are affected by changes in macroeconomic activity. When combined, these two components comprise the part of the yield spread attributed to default-related credit risks.

The illiquidity premium, a non-credit-risk factor, relates to a lack of general market liquidity. Moreover, the credit-risk and illiquidity premiums, like other risk premiums, can vary with any change in the risk appetite of investors and are therefore likely to be positively correlated over time.

They decompose the components of the corporate spread vs. governments using a structure “Merton” model, very similar to the BoE research previously reported on PrefBlog – the BoE is thanked for supplying code in note 16. For investment-grade firms issuing Canadian Corporate Bonds (they do not define their universe more precisely than this) they conclude:

As of 21 May 2008, while the actual spread was 179 basis points, the expected loss, credit-risk premium, and illiquidity premium were 20, 34, and 125 basis points, respectively. Comparable figures for end-July 2007 were 85, 21, 5, and 59 basis points, respectively. The increase in the investment-grade credit spread can thus be attributed to an increase in the credit-risk and illiquidity premiums above their recent historical norms.

… while noting:

The credit-risk component reached its peak level of 89 basis points in March 2008, and the illiquidity premium reached its peak level of 125 basis points in May 2008.

Much of the increase is due to the “high proportion of financial firms (approximately 55% of the index in 2007).”

There are some very illuminating graphs:

I will note that, as of June 25 according to Canadian Bond Indices and the HIMIPref™ Indices:

• 30-Year Canadas yielded 4.06%
• Long Corporates yielded ~6.05%
• PerpetualDiscounts yielded 6.01% as a dividend
• PerpetualDiscounts yielded 8.41% interest equivalent (at 1.4x)

See Party Like It’s 1999! for further discussion of the PerpetualDiscount Interest-Equivalent / Long Corporate spread.

This entry was posted on Thursday, June 26th, 2008 at 12:24 pm and is filed under Interesting External Papers, Spreads to Bonds. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.