Jason:
Nice post. However, let’s look at the following and point out to me why liquidity does not adversely affect corporate bond yields (please know I am not talking about junk bonds here)
1) Let’s first look at the correlation between liquidity and credit risks:
Liquidity risk refers to the chance that an entity will have insufficient cash flow to meet its obligations. This can be caused by the undesirability of an asset in the marketplace, such as a company’s products or fixed assets set for liquidation. It can also be caused by a slowing economy, longer Acct Receivable rates, etc.
Credit risk is the risk of loss due to non-payment of debts owed by an entity. So Credit risk may be compounded by liquidity risk.
2) We have to now assess where we really at in our economy. Are we still going further into recession, are we in process of taking steps to grow out of it, or are we already on the path to getting out of a recession. I pick the middle option.
So let’s now look at a portion of a key position paper from a widely regarded financial analyst named David Harper:
How Changes In The Credit Spread Affect The Bondholder
Predicting changes in a credit spread is difficult because it depends on both the specific corporate issuer and overall bond market conditions. For example, a credit upgrade on a specific corporate bond, say from S&P BBB to A, will narrow the credit spread for that particular bond because the risk of default lessens. If interest rates are unchanged, the total yield on this “upgraded” bond will go down in an amount equal to the narrowing spread, and the price will increase accordingly.
After purchasing a corporate bond, the bondholder will benefit from declining interest rates and from a narrowing of the credit spread, which contributes to a lessening yield to maturity of newly issued bonds. This in turn drives up the price of the bondholder’s corporate bond. On the other hand, rising interest rates and a widening of the credit spread work against the bondholder by causing a higher yield to maturity and a lower bond price. So, because narrowing spreads offer less ongoing yield and because any widening of the spread will hurt the price of the bond, investors should be wary of bonds with abnormally narrow credit spreads. Conversely, if the risk is acceptable, corporate bonds with high credit spreads offer the prospect of a narrowing spread, which, in turn, will create price appreciation.
But interest rates and credit spreads can move independently. In terms of business cycles, a slowing economy tends to widen credit spreads as companies are more likely to default, and an economy emerging from a recession tends to narrow the spread as companies are theoretically less likely to default in a growing economy. However, in an economy that is growing out of a recession, there is also a possibility for higher interest rates, which would cause Treasury yields to increase. This is a factor that offsets the narrowing credit spread, so the effects of a growing economy could produce either higher or lower total yields on corporate bonds.
Conclusion
If the extra yield is affordable from a risk perspective, the corporate bond investor is concerned with future interest rates and the credit spread. Like other bondholders, he or she is generally hoping that interest rates hold steady or, even better, decline. Additionally, he or she generally hopes that the credit spread either remains constant or narrows but does not widen too much. Because the width of the credit spread is a major determiner of your bond’s price, make sure you evaluate whether the spread is too narrow, but also make sure you evaluate the credit risk of companies with wide credit spreads.