Tuesday 16 September 2014 by Legacy

Record low yields on Australian corporate bonds – but what about credit spread levels?

What is a credit spread?

The credit spread represents the difference in yield an investor receives for holding a corporate bond over a benchmark with comparable maturity, usually government securities or the swap rate, and is usually expressed in terms of ‘basis points’ over a particular benchmark. The spread measures the perceived riskiness, as deemed by the market, of a security against the reference interest rate curve. Credit spreads contract as the credit quality of the bond is perceived to improve, and vice versa - a logical extension of this concept is that the weaker the credit rating of a particular bond, the higher its credit spread should be relative to a more highly rated (or less risky) bond.

When comparing the relative value of two bonds using their credit spreads as a comparison, it is important that the same reference benchmark be used to allow a ‘like for like’ comparison. For example, if the credit spread for particular bond is against the government bond yield, it would be erroneous to compare this to the credit spread of another bond, where that particular spread is expressed over the swap rate.

Historical bond yields and credit spreads in Australia

Recently, the Reserve Bank of Australia (RBA) produced two charts outlining the historical trends of both corporate bond yields and credit spreads on Australian corporate bonds for different credit rating bands.

The first chart below shows the history of corporate bonds yields in Australia across various credit ratings versus the comparable swap rate and Australian Government bond yield. As expected, the Australian Government bond yield, being perceived to be the ‘risk free’ rate, has always historically represented the lowest yield instrument.

Source: RBA

The chart above demonstrates that government and corporate bond yields in Australia are currently at record lows compared to the last 25 years of history. In fact, when we compare current Australian government bond yields to the last 150 years of historical government bond yields, we find that yields have only been lower than current levels approximately 10% of the time. The current low yields are reflective of the current very low cash rate set by the RBA and what has been a relatively benign state of affairs in global capital markets following the Eurozone crisis in 2012. In saying this, the recent spate of geopolitical tensions has seen moderate increases in government bond yields over September.

The second chart shows the history of bond credit spreads over the comparable Australian Government bond yield for the categories of bonds as reflected in the first chart.

Source: RBA

There are three observations we can make from the chart above. Most relevantly, whilst past historical spreads shouldn’t be used as a predictor of where future spreads go, what we can see from the above chart of credit spreads is that, whilst Australian bond yields are at very low levels compared to historical levels, the credit spreads for Australian corporate bonds are currently roughly double the levels of where they were at prior to the GFC. The bond market is still pricing for credit risk at levels well above ‘pre-GFC’, despite overall record low bond yields.

We can also see that, in times of severe market distress, such as the GFC and subsequently the Eurozone crisis, there have been large spikes in the levels of credit spread, followed by large corrections in credit spread levels.

Finally, this chart shows clearly the relationship between perceived credit risk and the level of credit spread – for example, bonds which fall into the ‘BBB corporates’ category show the highest spread relative to ‘A corporates’ and ‘AA corporates’.