Web Manual of Loans Tips

Spread volatility is one of the most important underlying drivers of nominal spreads. Investing in more volatile sectors requires a higher compensation (higher option adjusted spread) because it is more difficult to target projected returns. There is a close relationship between aggregate spread levels and aggregate spread volatility. Periods of tight spreads are accompanied by lower spread volatility. When spreads tend to widen the spread volatility will also increase.

Sector betas are used as a measure of risk and signal the systematic risk of a sector. Corporate bond betas are computed on the basis of spreads and are, like the equity betas, useful indicators for the assessment of the different risk profiles of various companies and sectors. A high beta indicates an above average investment risk, because it depends on the average leverage level of issuers from a sector. The change in betas over time reflects the change in relative risk of a sector versus the overall market.

The rating outlook of both rating agencies (S&P and Moody’s) can be another criterion to choose between industries. If companies with a positive rating outlook outweigh the companies with a stable or negative rating outlook within an industry, it can be a good indicator for favorable industry dynamics, even if we have to recognize that ratings are sometimes lagging indicators for credit quality. A diversified portfolio should overweight the industries with a positive rating outlook and underweight industries with a negative rating outlook if the whole credit market experiences a “Flight-to-Quality.” During a market phase with a higher risk appetite, fundamental factors like the rating trend in a specific industry might not be the primary decision criterion for a sector positioning and other factors like valuation
will play a bigger role.