A June 8th report from FactSet Insight focuses on the complex calculations that underlie corporate bond yields. FactSet Senior Product Developer Doruk Ilgaz, Ph.D explains the basic factors that determine corporate bond yields and goes on to discuss the complex and oft misunderstood “credit spread puzzle”.

Understanding the “credit spread puzzle” of corporate bond yields

Corporate Bond Yields

First, credit spread is understood to mean the component of corporate bond yields that is above the yield of default-free treasury bonds with comparable maturity.

Generally speaking, interest on a corporate bond is seen as the risk-free interest rate (such as on a 10-year treasury bond), plus a spread related to the credit risk of the firm issuing the bond. Ilgaz points out, however, that “empirical analysis of the determinants of corporate bond rates, however, has turned out to be more complex than it appears.”

Moreover, this complexity has led economists to talk about a “credit spread puzzle,” referring to the fact that spreads on corporate bonds are about twice as large as can be explained by defaults, taxes and illiquidity. Ilgaz also notes the higher the rating of the bond and the shorter the maturity, the more complex the puzzle becomes.

Ilgaz concludes: “The studies reviewed here show that more than half of the variation in corporate bond credit spreads is not related to the financial health of the issuing firm, but rather reflects effects such as compensation for liquidity risk (time varying), tax treatment of corporate bonds, and risk aversion of financial intermediaries. While the referenced studies contributed much to our understanding of the composition of credit spreads, the credit spread puzzle is still missing some key pieces.”

Taxes and liquidity risk only explain part of credit spread

Of note, the interest on corporate bonds is taxed both at the federal and state levels, whereas earned on treasury bonds is not taxed at the state level. Theoretically, this tax disadvantage for corporate bonds should create an upward bias to corporate bond yields to the extent of the tax disadvantage so as to balance the after-tax return in corporate and treasury bonds.

Ilgaz points out there are two arguments that mitigate the significance of the tax disadvantage. First, most corporate bond market investors, pension funds or other institutional investors for whom there is no difference in the taxes on the returns on corporate and treasury bonds. Second, significant changes to corporate tax laws are quite rare, which means that they can’t really be a primary factor in the large swings in bond spreads we see frequently today.

Also keep in mind that the the trading volume for corporate bonds is only a fraction of that of treasury securities. Investors require greater risk compensation for holding securities that are less liquid, and this liquidity risk premium is reflected through higher interest rate spreads relative to comparable treasury bonds. However, a 2005 academic study showed that about one-third of the credit spread is not explained even if you model in liquidity risk.