Question

Next, compare the CCC spread for a short-term maturity (such as two years) versus a long-term maturity (such as 10 years). Go to giddy.org/db/corpspreads.htm the spreads are listed in the form of basis points (100 basispoints = 1%) above the Treasury security with the same maturity.

a. Is the spread larger for the short-term or the long-term maturity?

b. Offer an explanation for this.

c. Notice that the difference in spreads for a given rating level among maturities varies with rating level that you assess. Oer an explanation for this.

Answer 1

I. Spread given here is the difference in yield between the treasury security and corporate bond of the same maturity. Corporate bonds need to pay higher return as they are comparatively more risky than treasury. More the risk, more return is expected from the bond to keep it in favor with the investor.

II. Bonds prices and yields are also sensitive to interest rate changes. As interest rate rises, price falls. The longer the maturity of a bond, the more it is affected by rate changes as more uncertainty of cash flows are involved.

a. & b. The 2yr spread for the CCC rated bond is 650 basis point (bps) or 6.5% whereas for the 10yr maturity of the same bond, the spread is 1300 basis point or 13%. Longer term bonds are more volatile than shorter maturity bonds (more sensitive to interest rate movements) and as such require additional interest. [Point II above]

c. Rating levels are given as per the risk quotient of a bond. As we move from AAA -> BBB -> CCC, the risk level increases. Higher the risk, higher the compensation required. [Point I above]

So, if we compare the spread of the 2yr bonds,

AAA (45bps) < BBB (130bps) < CCC (650bps)