Nondefault Components of Investment-Grade Bond Spreads

Traditionally, attempts at decomposing the spread between risk-free debt and corporate debt has focused exclusively on default risk. This focus continues despite the fact that the data indicate that the required spreads for higher-rated corporate bonds are normally far smaller than the spreads available in the market. This article challenges the traditional notion of an “excess spread” and, instead, attributes the additional spread to non-default-related factors, such as liquidity and spread volatility. The costs associated with both liquidity and spread volatility are examined, and a framework is provided for the investor to calculate adequate compensation for such costs. In theory, the difference in yield between a risk-free U.S. Treasury security and a non-risk-free bond should reflect the compensation required to equate the cash flows of the two securities (i.e., the yield premium, or spread, should simply reflect the risky security's expected loss relative to that of the risk-free security). In practice, however, the available market spreads for investment-grade securities are habitually greater than those required by even the most plausible loss scenarios. That the spread in the marketplace is greater than the “required” spread for expected losses raises the question of whether the corporate debt market is subject to systematic mispricing or whether this “excess spread” is, in fact, compensation for non-default-related costs.I propose that excess spread does not exist, because the spread takes into account certain non-default-related costs—namely, the costs of illiquidity and spread-volatility risk—that require as much consideration from certain investors, such as total-rate-of-return portfolio managers, as does default risk. This article provides a framework for investors who do not hold fixed-income securities to maturity to calculate adequate compensation for such costs. I do not use “liquidity” as a catchall phrase to mean “everything we can't explain.” On the contrary, I clearly define liquidity as a security's bid–ask spread and consider that liquidity involves the very real cost of buying and selling securities. “Spread volatility” is defined as the basis risk between a risky bond and a duration-equivalent Treasury security and involves the price risk between a risky bond and a risk-free bond.Illiquidity and spread volatility affect the investor who has a time horizon that is shorter than the security's maturity, and these risks must be examined as a component of that security's relative value. At its core, illiquidity involves the inherent price loss associated with crossing the market's bid–ask spread; spread volatility involves the price risk of the risky security versus the risk-free security. If the investor has a time horizon shorter than the bond's maturity, the investor risks that the terminal price of the security will underperform to the degree that its total return (i.e., incremental yield plus price change) is less than that of the risk-free security.The risks of illiquidity and spread volatility are every bit as real as default risk for investors who do not hold debt securities to maturity. Unlike default risk, however, which affects all investors equally, the costs of these two risks have a more subjective component: The required compensation varies with the constraints of the marginal investor. For this reason, a backtest of these costs with any type of realistic historical analysis is impossible. Rather, I outline how one might calculate these costs given a certain set of constraints.This framework involves a Monte Carlo technique to simulate bid–ask spreads and terminal spreads for calculating the holding-period returns that normalize the relationship between bonds with different characteristics. Additionally, I propose a risk-adjustment technique that allows the investor to customize return profiles to match a particular risk preference. This simulation, or option-based approach, gives the investor the ability to replicate the distribution around an expected outcome and to price the increased variability in a rigorous fashion to identify the most preferable return profile for the specific investor. This approach's advantage is that it allows the investor to customize a return profile and, hence, optimize return per unit of risk.