I’ve been asked several times why I use Yield Spread as my measure of default risk rather than simply using bond credit ratings. My answer is simple, Yield Spread is a continuously changing market characterization of risk, taking into account many factors that change all the time. In comparison, an agency’s credit rating is based on a snap-shot in time and only is only as good as the data used to analyze the company or bond offering. These days agencies are overworked and hard-pressed to keep up with the changing financial environment. I’d rather use a measure that changes daily.
Bond default probabilities can be derived from a bond’s market price because the spread between the bond’s price (and derived yield) and the risk-free rate of comparable treasuries (or the spot rate curve if you want to get technical) tells us what the market thinks about the default risk of that bond. It’s true that the yield spread tells us about more than the individual company — it also tells us about thoughts on the industry the company is in and the economy in general, but those are all relevent to default risk.
Using yield spread to manage risk in a bond portfolio makes sense with one caveat…it does require that the portfolio be much more carefully managed. Since yield spread can change much quicker than agency ratings, adjustment to the portfolio need to be made more often.
But who said effectively managing a bond portfolio should be easy?
