Credit risk premia and credit spreads - These are not the same

Specialized investing in credit risk premia is large and growing market but there are some simple definitions that will help with any discussion about rich and cheapness of premia. Most credit investors will analyze current spreads versus historical data and make a determination of whether they are being paid for the credit risk being taken. However, there is more going on if you truly want to get to the true credit risk premium. The real question is whether the risk premium received is enough to offset the risk of default and downgrade. These factors change with business and credit cycle. Spreads should reflect these risks, but there can be divergences between market prices and actual risks.

The true compensation for risk should account for the loss from a default and the loss from a downgrade. The downgrade risk can be measured through looking at transition matrices which track the likelihood of a downgrade over a time period versus the cost of a downgrade as measured by the differences in spreads with different ratings. The risk of a downgrade will change across the business cycle. If there is an expected recession, then there will be a highly probability that there will be a downgrade. Similarly, if there is economic improvement, there will be a greater likelihood of an upgrade in ratings.

A similar analysis can be done for the risk of a default. An investor needs to measure the likelihood of a default as well as the recovery value from a bankruptcy. The difference between the market price and recovery price will determine the size of the loss. Default probabilities will also change with the business and credit cycle. Hence, OAS spreads, as the weighted opinion on these credit issues, will change with the business cycle.

These credit issues are discussed in the white paper, "Where Has My Credit Premium Gone? A Perspective on the Current US Corporate Bond Market by Mellon Investment Management".

Many investors believe that the cost of downgrade and bankruptcy will be incorporated in the OAS spread, but a closer look at the data show that OAS spreads and credit risk premia are not perfectly correlated. As credit risks increase, there will be a corresponding increase in spreads as seen during recessions. This should be expected, but the difference between what is priced in the market and what is the likelihood of these risks being realized may not be the same. Any discussion of credit risk premia has to look at all of these factors to make an effective judgment on whether there is value in this risk premia.