Investors compare the yield on a corporate bond to the yield on a government bond or debenture to calculate corporate bond spreads. Investors also compare the yield of a corporate bond to mortgage-backed securities issued by government entities such as Fannie Mae, Freddie Mac and Ginnie Mae to calculate a bond spread. Changing bond spreads influence the value of the corporate bond. The price of the bond increases or decreases depending on whether the spread narrows or widens.
The purpose of calculating corporate bond spreads is to determine the value of the bond. This also helps investors assess the risk of a corporate bond investment. Investors assume a higher degree of risk when they purchase corporate bonds. In return for assuming this added risk, corporations issue bonds with higher yields than government bonds. For the purpose of calculating a corporate bond spread, investors compare corporate and government bonds that have the same yield to maturity and the same terms.
Credit rating agencies assess the probability of a corporation defaulting on its debt payments and assign the company a bond rating. The lower the probability is that a company will default on its debts, the higher its credit rating. The higher the probability of default, the lower the credit rating. Investors use government bonds rather than other corporate bonds to calculate bond spreads because the full faith and credit of the federal government backs government bonds. In other words, government-backed bonds carry very little credit risk because it is highly unlikely the federal government will default on its debt payments.
Investors consider a narrowing spread between a corporate bond and a government bond as positive. A common occurrence for bond spread narrowing is when a credit rating agency upgrades a bond. When this happens it means, according to the credit rating agency, that the company’s risk of defaulting on its debt payments is less than it was before. The price of the bond increases when bond spreads narrow. This drives the price of the bond up, making it more valuable and more attractive to investors.
Investors consider a widening spread between a corporate and government bond as negative. A downgrade in the company’s credit rating can lead to a widening spread. When a credit rating agency downgrades a corporate bond, it means the company’s risk of defaulting on its debt payments is greater than it was before. The price of the bond then decreases and it becomes less valuable. Bonds with widening spreads are less attractive to investors because they carry increased investment risk.
Certain economic conditions factor into corporate bond spreads. When inflation is on the rise, the credit risk for a corporate bond increases because the likelihood of default is higher due to rising prices. This causes the corporate bond spread to widen. When the economy is experiencing a period of growth, corporate bond spreads generally narrow because there is a lower likelihood of the company defaulting on its debt obligations during a time of economic expansion.