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.

Amajor reason why sectors experience significant shifts in their average ratings is the degree of cyclicality. Noncyclical sectors usually have a stable credit trend whereas cyclical sectors are heavily dependent on economic cycles and their rating outlooks move in tandem with the economy even though it has to be pointed out that the rating agencies try to rate through the economic cycle, meaning that cyclical swings should be incorporated in a company’s rating. Macroeconomic dynamics can drive the negative credit trend of industries and single companies, affecting their credit spreads even more than company-specific problems and risks. At this stage we want to point out that external shocks, which endanger geopolitical stability, can bring the whole economic system in disorder. After the tragic events of 11 September 2001 the airline and leisure industries were hit the hardest and a spread widening of 360 and 185 bps respectively was recorded. An average widening of 30–40 bps across all other sectors occurred in the short term, whereas the cyclical industries like automobiles showed higher spread movements than noncyclicals.