Web Manual of Loans Tips

The sensitivity of corporate bonds to the economic environment essentially depends on their time to maturity. In the short term, default risk for investment grade corporate issuers is primarily due to nonsystematic factors, for example, cases of fraud or litigation. Over longer term horizons, conversely, systematic factors tend to have a higher impact on the default probability of corporate issuers. Changes in the economic environment and business risks in the sense of adverse industry trends or increasing competition are major drivers of credit risk and hence for spreads in the longer term. Therefore, one would expect the spreads of long and intermediate investment grade corporate bonds to be more sensitive to indicators of economic activity than short-term bonds. This implies that credit curves should flatten when the economic outlook improves. Rising confidence in the corporate sector additionally spurs investors’ willingness to take on more spread duration. Consequently, in periods of spread tightening investors should expect credit curves to flatten. In other words, the slope of the credit curve and the level of credit spreads are positively correlated for investment grade issuers.

It can be stated that senior banks were less volatile than the telecommunications and automobile sectors. Especially the automobile sector and subordinated insurance increase the risk profile of a portfolio due to higher volatility and offer more potential to outperform/underperform the corporate benchmark if an overweighting is targeted. Services noncyclical and technology appear unattractive as they offer a relative low spread and a high spread volatility. The media, telecom and services cyclical sectors have an attractive risk-return profile and consequently should be overweight in a portfolio. The different spread volatilities of the sectors lead to divergent investor behavior regarding risk aversion /appetite, which in return results in different risk premia (spreads).

The rating differences between the various sectors have to be considered as well because in this example we compare AA-rated financials with low A/high BBB-rated telecommunication and automobile companies.