Bond Spreads Have Widened

Chart of the Week for February 6 - February 12, 2009

Bond yields generally reflect the base cost of borrowing plus costs for a number of risks, including the cost of credit worthiness, or the "risk premium". The U.S. Government is considered the gold standard for creditworthiness and its bonds are generally considered risk-free. The creditworthiness of corporate borrowers range from investment grade (moderate risk premium) to high-yield (higher risk premium). As the chart above illustrates, beginning in 2007 and continuing through 2008, bond investors have expressed their concern over the creditworthiness of corporate borrowers by fleeing the sector effectively pushing corporate bond prices down and yields up. At the same time, investors have been willing to pay more for the safety of U.S. Government bonds which has driven government bond prices up and yields down. This change in investor activity is called the "flight to quality".

The wider yield difference or spread from March 2007 through today appears similar, although more severe, than the last recessionary period in the early 2000's. During times of economic hardship or international crisis, the bond market tends to exhibit the flight to quality. In contrast, the declining or flat yield difference beginning in October 2002 and ending in March of 2007 reflected several factors such as ample liquidity and increased willingness to invest in higher risk bonds.

The current wide risk premium is evidence of the higher cost of borrowing for corporations. More stringent lending standards, as well as larger risk premiums have driven borrowing costs higher for many borrowers except those with stellar creditworthiness. Those higher borrowing costs and liquidity constraints have contributed to the current economic weakness and are a focus of U.S. Government efforts to improve the economy.

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