Do Yield Curve Inversions Also Occur in the Corporate Bond Market?
Understanding the Yield Curve
The yield curve is a graphical representation of the relationship between the short-term and long-term interest rates of fixed-income securities. It is commonly used with municipal and corporate bonds, but the most frequently analyzed is the yield curve of US Treasury securities.
An inverted yield curve occurs when the longer-term rates are lower than the shorter-term rates. This phenomenon is studied closely as it often precedes economic downturns.
One might wonder if the phenomenon of yield curve inversions also applies to the corporate bond market. This article explores this topic, providing insights into how and why inversions occur in the corporate bond sector.
The Corporate Bond Spread Curve and Inversions
In the corporate bond market,
the yield spread curve, which represents the difference in yields between corporate bonds and Treasury securities or swaps, can invert. This is a unique phenomenon that differs from the Treasury yield curve inversion.
For the full yield spread-curve to be inverted, the Treasury or swap curve would also need to invert. With corporations, the reasons for short-term rates being higher than long-term rates are extremely different from those in the Treasury market.
Corporate Restructuring and Risk Premiums
Consider a corporation undergoing restructuring. When such a corporation announces its plan and market perceptions suggest that the company will survive in the long term, the market will still price in a risk premium for short-dated bonds. This is because, if the corporation defaults and files for bankruptcy, it is likely to happen within the next 2 years.
During this period, the market adds a higher risk premium to notes maturing in 2–3 years. However, longer-dated notes and bonds will trade at lower rates. This is a clear indication of a corporate bond yield curve inversion.
Clues from the Transition Matrix
The transition matrix is a tool that examines the expected percentage of issuers that will upgrade or downgrade their credit ratings over the next year. This matrix can provide valuable insights into the health of corporations and the expected movements in the yield curve.
For instance, if you look at Table 20 on Page 52, you will find the transition matrix for US issuers. The crossover credits in this matrix show a divergence between upgrades and downgrades.
The matrix specifically focuses on the probability of a corporate staying at the same credit rating, upgrading, or downgrading within the next year. For example, AAA-rated issuers had a 100% probability of remaining AAA, while BBB-rated issuers had a 91.6% chance of remaining BBB, with 2.44% upgrading to single-A and 1.63% downgrading to BB. For BB-rated issuers, 86.18% remained BB, with 2.91% upgrading to BBB and 3.09% downgrading to B.
These crossovers in the matrix indicate where corporations might face higher risks, leading to an inverted corporate bond yield curve.
One key indicator of an inverted corporate bond yield curve is an inverted Credit Default Swap (CDS) curve, particularly for BBB, BB, and B issuers. If the CDS curve is inverted with a 2-10-year inversion, it suggests that the corporate bond yield curve is also inverted.
With the corporate bond market, especially the single-name CDS market, being highly liquid, we now have a powerful tool to gauge market expectations.
Understanding the dynamics of yield curve inversions in the corporate bond market is crucial for investors and analysts. It provides valuable insights into potential shifts in the economic environment and the likelihood of corporate defaults.
*Note: The transition matrix provided is a lookback analysis for 2018, from January 1, 2018, to December 31, 2018.