Credit spreads increase

As the hazard rate (or instantaneous probability of default) rises then the credit spread increases. 

As the recovery rate decreases the credit spread increases. 

Economic environment Where weak economic conditions and low expected growth increase the credit spread. Therefore, credit spread tends to increase during the economic recession and decrease during economic boom ... 

Like Black and Cox s work, the authors find spreads similar to the market spreads. Moreover, they find a correlation between credit spread and interest rate. In fact, they illustrate that firms with similar default risk can have a different credit spread according to the industry. The evidence is that a different correlation between industry and economic environment affects the yield spread on corporate bonds. Then, the duration of a corporate bond changes following its credit risk. For high-yield bonds, the interest-rate sensitivity increases as the time to maturity decreases. 

The findings show that by increasing time to maturity, bonds with high ratings have an increasing/flat credit spread curve, while low rated bonds have a hump-shaped credit curve. Moreover, the credit spread becomes wider as the value of w increases. 

The research compares the model spread to the one observed in the market. In order to determine the term structure of credit spread. Eons uses historical probabilities by Moody s database, adopting a recovery rate of 48.38%. The empirical evidence is that bonds with high investment grade have an upward credit spread curve. Therefore, the spread between defaultable and default-free bonds increases as maturity increases. Conversely, speculative-grade bonds have a negative or flat credit yield curve (Figure 8.7). 

The risk-free rate affects both elements, option-free bond and embedded option. Conversely, the credit spread is applied to the risk-free rate in order to find the price of the option-free bond. If the credit spread is also included into the option pricing model, the option value rises. For instance, consider the scenario in which the risk-free rate is 1.04% and the option value is 0.46. If the risk-free rate is 7.04%, then the option value increases to 0.66. Figure 9.16 shows the effect of a different interest rate level. 

Interest rates and credit spread A greater level of interest rates decreases the value of the option-free bond or bond floor. Because the credit spread is applied only into the bond floor valuation, a greater credit quality decreases the credit spread and interest rate, and increases the value of the option-free bond. Conversely, higher is the interest rates and credit spread, lower is the value of an option-free bond. 

In the Euro corporate market s short life, the level of credit spreads and spread volatility have increased almost beyond recognition. As we show in Exhibit 6.9, with the exception of the recovery from the market shock of 11 September 2001, credit spreads moved out more or less in a straight... 

The buyer has the right to buy the spread and benefits from the spread decreasing in value. The payoff has the form max (strike - spread, 0). This option pays out if the spread tightens below the strike level, a tightening spread would result in an increasing bond price. Therefore the credit spread call option provides a payout should the underlying bond position increase in value. 

A much easier method of generating leverage in a credit portfolio is through credit default swaps (CDS). They let investors take on or lay off default risk in an unfunded manner. Selling default protection enables one to receive the premium associated with the additional credit risk without the need to buy a bond of that entity, and in the process creates enormous leverage, especially for higher rated credits. The increased liquidity and the compression of bid/offer spreads have added to the attractiveness of this market. 

The credit spread reflects a number of macroeconomic and micro-economic factors, and at any one time is a good snapshot indicator of the perceived health and future prospect of the economy. For example, the reduction in spread from 2001 to 2004 reflects a general increase in favorable perception on the health of the U.S. economy, following the technology and dot-com boom and bust of the previous years and the market disruption following September 11, 2001. 

Corporate farming is on the increase and is not necessarily limited to large companies. In an effort to remain competitive two, three, or more family farms are joining together to form a corporation. Some of the advantages accruing to this type of operation are purchasing power, better credit, better use of equipment and mechanization, spread of the... 

That said, there are two reasons why the performance of German swap spreads are related to Euro peripheral spreads. The first one is that, flows apart, the bond-swap spread reflects the yield difference between a government rate and the composition of a string of EURI-BOR rates (i.e., a swap fixed rate). As the average credit quality of the banks in the EURIBOR panel is A-AA, any increase in the investors preference for credit quality will make both swap and peripheral spreads widen versus the core Euro government rate, thus increasing the correlation between both differentials. Yet this increase in the correlation will be mainly due to the outperformance of the benchmark asset... 

Swap spreads tend to narrow with slower economic growth, reflecting reduced corporate issuance and steady or increased high grade credit issuance. A good proxy for economic growth is capacity utilization. 

As credit becomes the new buzzword in Europe, portfolio managers have to pay attention to the spread or risk premium that they receive as compensation for taking on increased default risk. 

Asset allocation decisions by credit quality are similar to those for the yield curve but with an added dimension. When spreads widen, typically the lowest rated credits widen the most, and the spread differential between the triple-A and triple-B rated bonds increase, the opposite happens in cases where spreads tighten. Therefore, a portfolio with lower credit risk will generally outperform in a spread widening environment and vice versa. 

Practitioners increasingly model credit risk as they do interest rates and use spread models to price associated derivatives. One such model is the Heath-Jarrow-Morton (HJM) model described in chapter 4. This analyzes interest rate risk, default risk, and recovery risk—that is, the rate of recovery on a defaulted loan, which is always assumed to retain some residual value. 

The task of assembling nearly 250 articles from well over 60 authors has been formidable and I am grateful to the publishers and, in particular, to Jenny Cossham and Lynette James for their patience and to the authors for their cooperation. An increasingly dirigiste management culture has spread from industry into the quasi-privatized civil service and now into universities. This brings with it a narrow perception of the role and purpose of science and of research, which makes the production of material for a book such as this increasingly difficult. Its achievement is a credit to the dedication of authors involved. 

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