Australian Corporate Bond Spreads
Corporate bonds spreads are a cyclical indicator of the market's perception and appetite for credit risk. Generally corporate bonds are riskier than government bonds as reflected in their counterparty rating. The higher risk demands a higher return for any given rating and tenor. The extent of the return required varies with investor risk appetite. When risk appetite is high (spreads are low) then investors generally have confidence in the ability of borrowers to meet their credit commitments. Spreads widen due to uncertainty as to market conditions and concerns regarding economic risks grow. Widening corporate bond spreads can often be a leading indicator of economic downturns. Issuers of corporate bonds include major Australian corporations include airlines, utilities and property companies. Financial corporations (such as banks) also issue bonds but these are excluded.
As at mid 2024 bond spreads have contracted considerably as the major corporate bond issuers has demonstrated strong profitability despite recent interest rate rises.
The following chart provides the average Australian corporate bond spread to risk free since 2015. Risk free is calculated from the Australian Government Bond Yield of equivalent effective term.
Corporate bond interest rate measures
Source: RBA Table F3
Corporate Bond Yield Implied Probability of Default
The implied probabiility of default is derived from the bond yields by comparing the present value of the default risky cashflows with the present value of risk free cash flows from the a Commonwealth Government Bond of equivalent term. If a risky bond has a term of 3 years and a par yield of 2.8%pa (
where
If the borrower defaults on any coupon payment then all future coupons and principal are not paid and only the recovery rate is received. The recovery rate is one minus the loss given default (
Using a bootstrap, once the probability of default over the 3 year term has been determined, the subsequent probabilities of default for terms 5, then 7 then 10 are determined from the differences in the present value of loss from the extra term, assuming that the risk for the prior/overlapping period is the same of the risk for the shorter bond.
The loss given default is assumed and can vary substantially both for different borrowers (for instance based on industry conditions and business cycles), for different terms, and over time.
Bond yield implied default probabilities are often called risk neutral or quasi-default probabilities. This is because the rates are implied by market prices and convolute both the underlying credit risk of the borrower as well as market pricing risk premiums which compensates lenders for the capital loss from default. Some profit margin must be embedded in the interest rate. Bond yields also incorporate non-credit risks such as funding, liquidity and basis risk.
Bond risk premiums are similar to implied volatility in equity indices, they represent the crystalisation of traders risk appetite and uncertainties regarding future economic conditions. Given bond values are very sensitive to interest rates, the bond risk premium more strongly reflects interest rate expectations.
The market risk premium is derived as the difference between the acturial break even credit risk adjusted interest rate and the observed market interest rate. The acturial break even credit risk is derived from long run S&P observed default probability of equivalent cumulative effective term for all global corporates.
The break even credit risk adjusted interest rate is the interest at which the net present value of the loan is zero. It is reverse of the calculation of the quasi-default probability: in this case the default probability is known but the interest rate is unknown (the LGD is again assumed).
A generator matrix (derived from the exponential of the long run transition matrix) is used to calculate the default term structure in continuous time.