What the Treasury Yield Curve is Telling Us About Corporate Bond Yields

I learned from a dear friend of mine who manages high yield at Dwight Asset Management (one of the largest fixed income management shops that you never heard of), that with high yield bonds, spreads over Treasuries aren’t the most relevant measure for riskiness of the bonds.  Because they are more equity-like, high yield bonds have intrinsic risk that is independent of the level of yields in high quality bonds, the leading example of which are Treasury bonds.

In general, Treasury bonds can be thought of as a default-free debt claim (not perfectly true, but people think so), while other bonds must carry a margin for default losses.  As one moves down the credit spectrum, the riskiest corporate bonds act like equities, largely because as a company nears default, the equity of the firm is worthless, and true control of the firm is found in some part of the debt structure.
Spread curves of high yield bonds tend to invert when the Treasury yield curve is steeply sloped.   The slope of the Treasury curve for that effect to be active now, particularly since high yield spreads have widened out from earlier in 2007.  The effect can be seen though, in higher quality investment grade bonds.  Given the lower spreads over Treasury yields on investment grade debt, the relative uncertainty in the present economic environment, and the lack of liquidity in the short end of the yield curve, it’s no surprise to find the spread curve inverted on Agencies, and flattish, but still positively sloped for single-A and BBB corporates.

What this means is that there are intrinsic levels of risk affecting the yields on high quality corporate debt, lessening the positive slope of their spread curves, or with agencies inverting the spread curves.  As the Treasury curve gets wider in 2008, those corporate  spread curves should flatten, and then invert, unless more macroeconomic volatility leads to still wider credit spreads, or a rise in short term inflation expectations causes the yield curve to stop widening.

Another way to say it is that if the short end of the Treasury yield curve falls dramatically, don’t expect the yields corporate debt to follow suit to anywhere near the same degree.

4 Comments

  • What is the “spread curve of high yield bonds?” If I had access to the data directly, how would I calculate it? I assume it’s a quality spread of corporates, but it’s always nice to have a definition nailed down, so we’re all talking about the same thing.

    While you’re at it, a good definition of the T-yield curve would be nice, since I’ve seen it as the 10/2 difference, the 10/2 ratio, the 10/FFR difference, the 10/FFR ratio, and could imagine various other ways to calculate it. Definitional problems lead to other problems.

    It’s easy to buy that the quality spread between junk corporate and Ts isn’t the most relevant metric.

    It’s NOT so easy to buy that the quality spread between, say for example, As and junk, tends to invert when the TIME spread on Ts, say for example, difference between 10/2, gets steep.

    I’d like to see data on that, if you have it.

  • Bill, I’m having some difficulty posting non-text data, but when I get it resolved, I’ll post some graphs on this topic.

  • Sounds good. What about your working definitions? They would be text data.

    Out of all the different timeframes available, how would you define the measurement of the T yield curve? Difference of two rates (which two?), ratio of two rates (which two?), or some mathematical function of more than two rates?

    Do you define the spread based corporate rates? If so, how? Difference of two rates (which two?), ratio of two rates (which two?), or some mathematical function of more than two rates?

    If they really are inversely related, a correlation coefficient and the definitions behind it (curve definitions, date ranges of data used, definition of data points [as in monthly evaluation points from 1975 through 2007]) all would be text data.

  • Bill, I can put all of that together, but I am adding it to my article list. I’ll give you a quick answer on yield curve slope, though. I use the definition that is pretty standard among bond investors — 10-year yield less 2-year yield. Difference, not ratio. Bond investors call that “the belly of the curve.” (Sometimes that phrase is more closely applied to the 3-7 year portion of the curve.) It represents the bulk of the investable bond universe.

    I look at the whole curve, though. The front end tells us about the money markets, 0-2 years. The long end tells us about long term liability defeasance, such as with defined benefit pensions, or structured settlements (10+ years).

    So, my simplified yield curve has three joints to it: short (3-month), 2-year, 10-year, and the long end (usually 30-years).

    As for the correlation matrices, detailed data on corporate yields really did not exist until the early ’90s, partially because corporates traded on a dollar basis, and spread data were not retained. There are a few yield series that are useful for relative purposes, like the Moody’s series, but they are blends of many maturities.

    On Treasuries, we can go back a long way (’20s), but I think the period prior to floating exchange rates is less relevant to the way the yield curve currently behaves. Monetary policy is different, and so are yield curve dynamics.

    I used to do yield curve modeling for life insurance companies. My best model was a lognormal multivariate mean-reverting model, which behaved realistically. (The Society of Actuaries has a better one for the Treasury curve, but mine did credit spreads as well.) I don’t have access to that model now (client property), but I could develop it again. It would take some time, though, and I am getting close to starting a new job, so time is limited. When I write the article, I can try to divulge it all. That’s probably not one article, but a series.