The Influences of Corporate Bond Spreads

When pricing bonds, corporate issuers consider the potential yield a bond could have when compared to other bonds on the market. Typically, the issuer will compare the bond to both higher risk and lower risk options. For example, a corporation with an A rated bond could compare to both a treasury bond, very low risk, and a BB rated bond, very high risk. The comparison in the potential yields while accounting for the risk is called the bond spread. Bond spread, then, is determined both by risk and yields.

Risk of a Corporate Bond

The first factor to take into account when considering bond spread is the comparable risk of the bond. It is hard to say whether a bond is risky or not without comparing it to other bonds. Thankfully for investors, there are several ratings companies that do this for the general public. For example, Standard & Poor's and Moody's both set ratings based on estimated risks associated with various corporate bonds. The ratings use an A, B, C system, with many levels in between. Most people will only consider bonds with a BBB rating or better, which means the bond is "investment grade." Even a corporate bond with a AAA rating, though, will be riskier than a treasury bond. Treasury bonds are the most predictable types of bonds on the market because there is essentially no risk the issuer, the federal government, will not default on the debt.

Yield of a Corporate Bond

If risk was the only factor that mattered when purchasing a bond, everyone would purchase treasury bonds. However, there are other factors of importance. Most important is the bond's yield, which is paid in interest payments or dividends. Some bonds will not make regular interest payments but instead calculate the yield at the end of the life of the bond. In any case, the estimated yield on a bond is estimated at the time of its purchase. Over time, investment houses and ratings companies create statistics on average bond yields across industries and corporations. This will be used in comparison to the general risk associated with the bond to calculate the bond spread compared to other bonds.

Bond Spread and Pricing

Bond spread tells investors a bond's estimated worth, based on the two primary factors. A bond that has a low risk level, but low potential return, may be ranked beneath a bond with slightly more risk, but far more potential return. Bond spreads, like nearly all investment rating systems, are only estimates based on past performance and market predictions. They are never set, and they may change each day or each month. However, on a given day, a bond is priced relative to its spread on the market. The prices of bonds higher on the list will be higher. This adds a third factor to the equation of selecting which bond to purchase. Ultimately, bonds across the spread can be mixed to select a well-diversified bond portfolio and spread the cost of high performing bonds with the cost of low performing bonds.

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