RDP 2012-09: A History of Australian Corporate Bonds 6. Corporate Bond Pricing

It is market convention for corporate bond yields to be quoted as a spread, often to CGS or swap. This spread reflects the credit, liquidity and market risks inherent in bonds and tends to be higher and more dispersed during periods of economic and financial difficulties.[23]

A comparison of spreads on government-guaranteed bonds to those on non-government guaranteed bonds is available over a long period time and is a useful proxy for credit risk differentials (Figure 9). During periods of greater uncertainty about economic and financial conditions,[24] spreads on non-government guaranteed bonds averaged 166 basis points, compared to 84 basis points for guaranteed bonds. In other periods these spreads averaged 99 basis points and 40 basis points, respectively. These spread differentials illustrate the increased compensation for credit risk during periods of market difficulties.

Figure 9: Corporate Bond Spreads at Issuance

Spreads have, on average, been higher for bonds with lower credit ratings (credit rating data is only available for Australian corporations since the early 1980s) (Table 3). However, there is considerable ‘overlap’ between spreads on bonds with different credit ratings, such that a bond rated BBB could have a lower spread than a bond rated AAA.[25] This overlap occurs mostly during periods of favourable economic and financial outcomes, such as following the early 1990s recession. During this period there was significant compression of spreads across investment-grade bonds, with the differential of spreads between bonds rated AAA and A declining to 34 basis points, compared to 83 basis points during the early 1990s recession. This led to a corresponding rise in the proportion of bonds with similar spreads, but different credit ratings. Around 90 per cent of BBB-rated bonds issued between 1993 and June 2007 had spreads at issuance comparable to bonds rated AAA (Figure 10). In contrast, only around one-third of BBB-rated bonds issued since the global financial crisis have had spreads at issuance comparable to AAA-rated bonds.

Figure 10: Corporate Bond Spreads at Issuance
Table 3: Australian Corporate Bond Pricing
Average spread to CGS
1983–1989(a) 46 58 82  
1990–1992 30 73 113  
1993–2007:H1 44 48 78 112
2007:H2-2011 120 156 243 316

Notes: Bonds issued onshore and offshore by Australian corporations over selected periods; bonds with a 3–6 year tenor
(a) Sample commences from 1983 when Standard & Poor's commenced rating Australian entities

Sources: Bloomberg; RBA


It is worth noting that economic downturns are not the only explanation of the time series variation in spreads: the corporate bond issuer base (including by credit rating) tends to broaden during periods of strong economic growth, which can lead to a rise in the dispersion of spreads across the market as a whole. [23]

Defined as the periods 1929:Q1–1931:Q4, 1960:Q2–1961:Q2, 1974:Q1–1975:Q1, 1982:Q1–1983:Q1, 1990:Q1–1991:Q2 and 2007:Q3 onward. The most recent issuance of government-guaranteed bonds was by banks during the global financial crisis rather than publicly owned corporations. The lack of pricing data around the time of the Great Depression and WWII is due to a lack of issuance during this period, reflecting the weak economic conditions at that time. [24]

This overlap of spreads across credit ratings reflects the fact that credit ratings capture one measure of risk borne by investors, but not all risks. Other risks that are likely to be priced into bonds include differences in liquidity (with less liquid bonds typically having higher spreads), and investors' expectations of changes in credit risk and ratings during a bond's life. Some of the spread overlap is also explained by differences in bond maturities, as our sample here includes bonds with maturities of between 3 and 6 years. [25]