Credit spread

The higher the CDS spread, the worse the rating, as the example of some European countries (February 2, 2015) shows.

The credit charge or credit spread as Anglizismus also credit spread known (German also yield difference or yield range ), is in the finance , the difference between the two rates, namely a high-risk and a risk-free rate of the same term . It indicates the risk premium that an investor receives as compensation for the credit risk taken .

Word origin "Credit Spread"

The Anglicism "spread" is used as a spread, i. H. To translate difference, span or margin and generally refers to any difference between two observed quantities. The credit spread is the difference between the return on a risky bond and the return on a quasi-risk-free benchmark with otherwise identical conditions (especially the term). Under credit was understood since 1959 only the issuer risk of corporate bonds as the credit spread originally exclusively as a measure of risk for credit risk used by bonds. Since then, the spreads of corporate bonds with risk-free government bonds and of government bonds from different countries have been compared .

Later, the credit markup or “credit spread” in banking was widened to include all credit risks , even entire loan portfolios . As a measure of the credit risk, it contains expectations about the probability of default and the recovery rate in the event of loan defaults . Bonds and loans come into question as interest-bearing assets. If a German credit institution holds a foreign government bond in its portfolio, the credit premium is the difference between the yield on this bond and the yield on a federal bond with the same term.

calculation

The credit add-on compares the returns on two bonds with each other or a loan with a risk-free bond:

${\displaystyle {\mbox{Kreditaufschlag}}={{\mbox{Rendite einer Anleihe oder eines Kredits}}-{\mbox{Rendite einer risikolosen Staatsanleihe mit gleicher Laufzeit}}}}$

A “risk-free government bond” as a reference object is a theoretical construct, since government bonds are never entirely free of default risks. The fact that states are not exposed to any credit risk has been empirically refuted in financial history. In practice, for the sake of simplicity, government bonds with an AAA rating are assigned the attribute “risk-free”. The fact that government bonds promise different returns within this top credit rating class is then not explained by differently assessed credit risk, but by the influencing factors market liquidity and taxes .

A risk-free government reference bond must meet three conditions:

• It must be free from the risk of failure.
• It must map the entire range of maturities.
• It must be actively traded in a liquid market.

Bonds that have been issued by countries with the best credit ratings are considered to be free of default risk in this context. These include Germany and the USA. In addition to government bonds from such countries, swaps and Pfandbriefe are also viewed as free of default risk.

Credit risk

The credit risk is linked to the creditworthiness of the issuer . Rating agencies such as Standard & Poor’s (S&P), Moody’s and Fitch Ratings classify the creditworthiness of issuers according to a standardized process. The result of the assessment of the future ability to repay debt is the rating , i.e. the classification of the issuer in a credit rating class. Issuers in the same credit rating should accordingly have credit spreads of a comparable size.

The credit risk can be broken down into migration and default risk . Migration risk is understood as the risk that the issuer's creditworthiness will deteriorate and the market price of the bond or loan will therefore fall. In this case, the creditor suffers a loss of assets equal to the price change. The migration risk is often operationalized by changing to another rating class.

The default risk is a special case of the migration risk. The bond migrates to the worst rating class, the default class. The bond fails and the investor only receives a portion of the outstanding interest and repayment payments.

Spread risk

Even if the credit quality of an issuer is constant, the credit premium fluctuates over time. If the credit spreads rise because of the increasing risk aversion of capital market players, all other things being equal, the prices of corporate bonds fall . Investors suffer a loss of wealth. The spread risk is particularly evident in capital market crises, such as was observed during the LTCM crisis in 1998 or during the subprime crisis since 2007.

Liquidity risk

Liquidity expresses the tradability of bonds. A bond investor is exposed to liquidity risk if he cannot sell a position at a given market price but only at a discount. The price of liquid bonds is higher than that of illiquid bonds. Therefore, illiquid bonds have a higher yield and thus a higher credit spread.

Consideration of the partial risks

Not all the risks of a corporate bond are included in the credit spread. The interest rate risk is excluded from the systematic risks (market risks) - to which "risk-free" government bonds are also exposed - and only the spread risk is taken into account; of the unsystematic (company-specific) risks, only the credit and liquidity risks are part of the credit premium. The credit premium represents a risk premium for the credit, spread and liquidity risks assumed with the investment .

Types and causes

In addition to the absolute credit premium, the actual return difference, one also considers the relative credit premium as the quotient of the return difference and the risk-free return. In the low-interest environment - when the risk-free return is close to or even below zero - it is pointless to consider the relative credit spread. In a “normal” interest rate environment, the relative credit spread is a more stable variable than the absolute one. This is because the absolute level of the interest rate also influences the size of the credit spread. As a rule, otherwise comparable bonds have higher credit spreads the longer their term.

A credit spread does not only tell how the credit or capital market assesses the probability of default of a debtor . Rather, company and bond-specific risks also flow into the credit spread. Company-specific, liquidity and tax issues and, in the case of loans, also the question of the duration of a business relationship between lender and borrower must be taken into account. Market risks include event risks that are not company-related but are caused by financial transactions such as company takeovers , recapitalizations or share buybacks in other companies.

Rating

The worse the credit rating, the higher the probability of default and the higher the credit premium is in normal cases. In theory only, bonds or loans with an identical rating have the same credit premium to the risk-free reference bond . Rather, it became apparent that debtors with the same rating had different credit spreads in the market. One reason for this is that rating agencies are not always based on current information. In particular, the agencies endeavor, within the framework of their “through-the-cycle” philosophy, to keep ratings largely constant and independent of economic influences. In contrast, the market takes current developments and expectations into account on a daily basis and prices them. This is why credit spreads also react faster to changes in creditworthiness than rating classifications.

In order to eliminate the grossest discrepancies between credit spreads and ratings, the agencies have, after experience with sudden rating gradations over several levels up to the speculative or junk status (" fallen angels ") of the past, started in 2002 to include current market developments such as the To consider credit spreads more in their ratings. The credit spread can therefore affect the rating - not just the other way around.

In the case of collateralized debt obligations (CDOs), however, it became apparent during the financial crisis from 2007 that they had a considerable credit premium over US Treasury bonds, even though both were rated AAA. The market had therefore seen a much higher risk in the CDOs than was reflected in the credit rating. As it turned out during the financial crisis, the CDOs contained considerable cluster risks with positive correlations of the real estate loans securitized in them, which the rating agencies did not take into account in their credit ratings.

Credit Default Swaps

Credit Default Swaps (CDS) are credit default swap transactions and as such are useful for hedging the risk of default. Their pricing includes a credit premium, the so-called CDS spread. Bond-based credit spreads and CDS spreads differ in their amount. If government bonds are used as a risk-free reference, credit spreads regularly exceed CDS spreads. While credit surcharges have to be calculated as a difference, CDS spreads are directly available via stock exchange information systems for numerous issuers and various remaining terms.

In theory, the market price of a credit default swap is the same as the credit premium for the same borrower and the same term. Credit default swaps, which hedge the default risk of an underlying , provide a direct indication of the amount of the credit spread, since the CDS premiums represent the difference to the risk-free government bond. For example, if the risk-free return on a three-year bond is 2.9% and the three-year CDS premium on a given borrower is 60 basis points, the return on a three-year corporate bond from that borrower should be 3.5%.

The credit spread corresponds to the expected loss in banking operations: The expected loss (from a one-year perspective) is the product of the average annual probability of default and the default loss rate :

${\displaystyle {\mbox{Erwarteter Verlust}}={{\mbox{Ausfallwahrscheinlichkeit}}\cdot {\mbox{Ausfallverlustquote}}}}$

Risk management

Risk management is intended to contribute to the systematic identification, analysis, assessment, monitoring and control of risks in companies . Since credit spreads have now established themselves as a current risk measure, they have become a key risk indicator for risk management in banks and insurance companies. By regularly evaluating them and comparing them with ratings on the one hand and CDS spreads on the other, important insights into the current creditworthiness assessment of debtors can be obtained.

Individual evidence

1. ↑ Definition of SPREAD. Accessed August 29, 2018 . 
2. ^ Lawrence Fisher, Determinants of the Risk Premiums on Corporate Bonds . In: Journal of Political Economy . tape 67 , no. 3 , 1959, pp. 217-237 (English).
3. ↑ Of the many government bonds that were exposed to at least partial debt relief , the following are mentioned: Russian crisis ( August 1998) with up to 70% default, Argentina crisis (December 2001) with 65% default, Greece crisis with 53.5% default (October 2011).
4. ↑ Alois Geyer, Stephan Kossmeier, Stefan Pichler: Measuring Systematic Risk in EMU Government Yield Spreads . In: Review of Finance . Vol. 8, No. 2 , 2004, p. 171–197 , doi : 10.1023 / B: EUFI.0000035191.62455.32 (English). Here pp. 194–195.
5. ↑ ^{a b} Matthias Schlecker, Credit Spreads , 2009, p. 12.
6. ↑ Heiko Staroßom: Corporate Finance Part 2, Financing in the phases of a company's life , 2013, p. 495.
7. ↑ Heiko Staraßom: Corporate Finance Part 2, Financing in the life phases of a company , 2013, p. 591.
8. ^ Gunter Löffler: An anatomy of rating through the cycle . In: Journal of Banking and Finance . tape 28 , 2004, pp. 695–720 , doi : 10.2139 / ssrn.275842 (English, online [PDF; 351 kB ]). Here p. 695.
9. ↑ Alexander Olbrich: Impairment of financial assets in the category "amortized cost" according to IFRS 9 (=  accounting and auditing . Volume 36 ). BoD - Books on Demand, 2012, ISBN 978-3-8441-0125-6 , pp. 84 ( limited preview in Google Book search).

literature

• Matthias Schlecker: Credit Spreads - Influencing Factors, Calculation and Long-Term Equilibrium Modeling (=  Series Financing, Capital Markets and Banks . Volume 66 ). Eul Verlag, Lohmar / Cologne 2009, ISBN 978-3-89936-812-3 ( information ).
• Ulrich Pape, Matthias Schlecker: Calculating the Credit Spread . In: Finance Operations . Volume 10, No. 10 , 2008, ISSN  1437-8981 , p. 658-665 ( information ).