CFA Level II ExamFixed IncomeMedium
A bond investor is evaluating the credit spread of a corporate bond. Which of the following factors would most likely lead to an increase in the bond's credit spread?
- AAn increase in the bond's embedded put option value.
- BA decrease in the liquidity of the bond.
- CAn upgrade in the issuer's credit rating.
- DA decrease in the market's overall risk aversion.
Show answer & explanationAnswer & explanation
Correct answer: B. A decrease in the liquidity of the bond.
A credit spread reflects the compensation investors demand for taking on credit risk and other non-interest rate risks (like liquidity risk). A decrease in the bond's liquidity means it is harder to sell quickly without a significant price concession, making it less attractive to investors and thus requiring a higher yield (wider credit spread) to compensate for this illiquidity.
Why the other options are wrong
- A. Incorrect. An increase in the value of an embedded put option makes the bond more attractive to the investor (as they have the right to sell it back). This increased attractiveness would typically lead to a narrower credit spread, not a wider one, as the bond is less risky for the holder.
- C. Incorrect. A credit rating upgrade indicates lower credit risk, which would typically lead to a decrease (narrowing) in the bond's credit spread.
- D. Incorrect. A decrease in overall market risk aversion would generally lead to investors accepting lower compensation for risk, thus narrowing credit spreads across the market.
Credit Spread Determinants
A bond's credit spread is the additional yield an investor demands above a comparable risk-free bond to compensate for credit risk, liquidity risk, and other non-interest rate risks.
- Primary driver is credit risk (probability of default, loss given default).
- Liquidity risk also contributes to the spread.
- Market risk aversion influences overall spread levels.
- Embedded options can also impact the spread (e.g., call options widen spread, put options narrow spread).
Memory trick: Spreads 'stretch' for risk, 'tighten' for safety.