Magic Flat Credit Card Cube

It is important to note that upward sloping credit curves imply a widening of spreads, flat credit curves imply stable spreads and inverse credit curves imply tightening spreads. Again, as with government bonds implied spreads differ from expected future spreads. Longer term corporate bonds should not only contain a premium that compensates investors for accepting higher price volatility, but also for taking on additional credit risk.

Traditional credit analysis is a bottom-up approach which focuses on the selection of companies. The credit quality/risk has to be determined and the two following questions have to be answered:

• Is the issuer able to make the coupon payments?
• Will the company value at maturity be large enough to pay back the principal?

During highs and lows of market cycles psychological and technical factors tend to push asset prices to extremely elevated or depressed levels. At those times it is appropriate to focus on credit fundamentals and detect companies where such moves were not justified. Credit analysis should be able to identify opportunities to add substantial yield by assuming only little higher credit risk at the same time.

A second observation with respect to forward credit curves is related to the slope: The steeper a credit curve is, the larger is the implied spread widening. If the spread widens less or more than indicated by forward spreads over the holding period, certain bonds will perform better than others. Portfolio managers who have a strong view on the spread changes they expect for an issuer’s bonds may benefit from this fact. If, for example, they expect the bonds of an issuer with an upward sloping credit curve, to widen less than implied by forward spreads, they would prefer to own longer term bonds, because the additional carry should overcompensate the capital loss due to the expected spread widening.