Break a yield spread down into the parts that make it up
The idea
The spread of a corporate bond over a government benchmark compensates for more than expected credit loss. It contains a credit risk premium for the uncertainty of that loss, a liquidity premium for the cost and difficulty of trading, a tax component in some markets, and often a premium for the risk that the spread itself widens before the bond matures. Empirically, expected default losses account for only a fraction of observed investment grade spreads, which is why a strategy priced on default probabilities alone appears to find free money and does not.
Formulas
G-spread over the government benchmark
G-spread = bond yield − government yield
- bond yield
- the yield to maturity of the bond being analysed
- government yield
- the yield on a government bond of the same maturity, interpolated when none matches
What is left once the risk-free rate is taken out: credit, liquidity and, for a bond with options, the option. The I-spread measures the same bond against swap rates instead, which is why the two differ even on the same day.
A practice question
Which component of a corporate yield spread compensates for the difficulty of trading the bond?
- The liquidity premium — correct
- The expected loss componentWhy not: Probability of default multiplied by loss given default, which concerns the issuer rather than the market for its bonds.
- The tax componentWhy not: Relevant where interest is taxed differently from other income, as in some municipal markets. It has nothing to do with tradability.
Investors require extra yield for an instrument that is costly to buy and sell. It is a substantial part of the spread, especially for smaller issues.
A harder one
Why does a strategy priced on default probabilities alone appear to find free money?
- Because spreads are quoted incorrectlyWhy not: Spreads are quoted accurately. What is wrong is the assumption that default risk is all they pay for.
- Because default probabilities are always overstated by the agenciesWhy not: Realised default rates broadly track agency estimates over long periods. The gap is in what else the spread compensates for.
- Because expected loss is only part of the spread — correct
The rest looks like unearned income until its risks arrive. The remainder is compensation for liquidity and for spread volatility, both of which show up as losses at inconvenient moments.
The hardest tier
How can an investor lose money on a bond that never defaults?
- Only through a coupon reductionWhy not: A fixed coupon cannot be reduced, and failing to pay it would be a default.
- They cannot, if the bond pays in fullWhy not: Only true for a holder who is certain of never selling. An investor facing redemptions cannot promise that, and the mark moves in the meantime either way.
- Through a spread widening — correct
A wider spread erodes the mark and can force a sale below cost. Default is a terminal event; almost everything a credit investor experiences happens before and without it.
In the app: 12 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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