Credit spreads and corporate bond distress - A non-linear relationship

 

There is a strong link between the NY Fed corporate distressed bond index and actual spreads as measured by the ICE BofA BBB and CCC OAS spread indices. For more information see New NYFed Corporate Bond Distressed Index provides context for spread increases.

The correlation with the distressed index is relatively high, but more importantly there is a non-linear relationship between stress and spreads. The core relationship is slightly positive but above a reading of 50 there is a significant increase in slope. There is a lever of distress and risk that converts into increased spreads. 

Corporate spreads will increase during economic slowdown and greater risk of defaults, but spreads will also increase with the endogenous risk from declines in trading liquidity and increased bid-ask spreads. The trading structure matters especially when markets are under financial stress.