Factors Driving Bond Spread Changes

“Are Corporate Bond Yields Truly Aligned with G-Secs? A Closer Look” By Venkatakrishnan Srinivasan | Rockfort Fincap LLP In India’s fixed income market, it’s often assumed that AAA-rated corporate bond yields—especially PSU issuances—move in tight alignment with corresponding government securities (G-Secs), maintaining a relatively stable spread. But is this assumption always valid? In my view, corporate bond yields are only correlated to G-Secs—not anchored to them. Yes, the G-Sec curve often acts as a reference point. But in practice, bond yields—particularly in the AAA PSU segment—are driven far more by technical factors, regulatory mandates, and liquidity dynamics than by sovereign yields alone. Case in point: The COVID period. During the height of the pandemic, we saw several long-tenor AAA PSU bonds trading inside corresponding G-Secs. Why? Massive liquidity injection, heightened demand from insurance companies, pension funds, and EPFO—all operating under tight investment mandates—led to an artificial compression in spreads. The market wasn’t pricing just credit; it was pricing regulatory compulsion. On the flip side, decade(s) ago, AAA spreads blew out to over 300 bps in certain pockets, despite a benign macro backdrop. In both extremes, G-Sec yields were not the dominant driver—demand-supply and regulatory behavior were. Today, we see a curious shape to the AAA-GSec spread curve: • 1-year spreads: ~90 bps • 3-year: ~85 bps • 5-year: ~70 bps • 10-year: <50 bps This flattening at the long end is a function of investor preference, not fundamental credit repricing. Long-only investors prefer predictable cash flows, and AAA PSU bonds are quasi-sovereign anyway. As demand gets concentrated in these tenors, spreads compress, regardless of what the G-Sec is doing. Bottom line: We must move beyond simplistic assumptions that corporate bonds move with G-Secs. They move around G-Secs, influenced by a host of forces—liquidity, regulation, investor constraints, and, occasionally, sentiment. Understanding this nuanced relationship is key to navigating India’s evolving bond market—especially as we head into a fiscal year where both liquidity and policy stance are turning supportive. ⸻ Follow Rockfort Fincap for more institutional insights on the Indian bond market. https://lnkd.in/dzu382xT

With equity volatility creeping up in August, attention is shifting to credit markets given equity volatility is a key component of credit spread valuation models. While the VIX index has moved up to 17% from a low of 13% in July, credit spreads are little changed and have yet to respond to the rise in equity volatility. The valuation challenge for credit would become bigger if the rise in equity volatility persists, if government bond yields rise further or if the downgrade/default cycle evolves. In fact, compared to government bonds, credit looks already expensive as implied by the low level of corporate bond spreads compared to government bond yields. The rise in downgrades including downgrade reviews by ratings agencies suggests that a US credit cycle is already evolving. Rating downgrades including downgrade reviews typically precede defaults and are more timely indicators of credit perception changes. Indeed defaults appear to be following rising downgrades with this year’s volume of defaults on track to be the third highest on record in dollar terms. Rising downgrade risk appears to be already putting downward pressure on total vs. credit spread returns. The other valuation challenge for publicly traded credit markets stems from their comparison with private credit markets. Over the past year activity from public leveraged loan markets has shifted to private credit markets, suggesting price discovery for new credit is increasinglytaking place in private markets. And the yield divergence between private and public credit markets remained wide in July at around 300bp, posing a valuation challenge for public credit markets. Finally delinquencies are rising in consumer credit and commercial real estate. The Trepp US CMBS delinquency rate for office jumped by 338bp since December, suggesting that the deterioration in credit quality in office sector may already have entered a non-linear phase. Moreover, Trepp reported for July a greater rate of delinquency for larger (above $50m) loans, a rare occurrence as typically larger loans have lower delinquency rate. This occurrence happened only twice in the past during periods of economic weakness I.e. in July 2012 and June 2020 when the overall delinquency rate went above 10% in both cases. In all, rising downgrades, defaults and delinquencies suggest that a US credit cycle is emerging which is likely to worsen into 2024 given stalled credit creation and persistently high refinancing costs.

🧠 Two Credit Spread Indicators to Watch Even if you are not a direct investor in credit bonds, sometimes it pays to watch the credit spreads for signs of cracks in the market before equity markets fully react. We'd rather be early than late right? When assessing the general credit health of the market, two signals deserve close attention: the #CDX Investment Grade Spread and the ETF I-Spread (as seen in #LQD). 📌 1. CDX Investment Grade (White Line on Chart) A synthetic measure of credit risk, CDX represents the cost to buy protection on a basket of investment grade (IG) names via credit default swaps (CDS). A rising CDX = rising fear. Since it is a synthetic, liquid market, it is often the fastest-moving credit risk barometer, reacting instantly to macro shocks, liquidity crunches, or systemic risk. Think of it as the "credit VIX" — high-frequency and highly sensitive. 📌 2. ETF I-Spread (Orange Line) The I-Spread compares the yield of a bond ETF like LQD to a duration-matched Treasury. Higher I-Spreads = investors demanding more compensation for credit risk in cash bonds. This spread reflects supply/demand pressures, ETF flows, downgrade concerns, and broad credit appetite in the cash bond market. 📉 Why These Indicators Matter When both CDX and I-Spreads are rising, the market is flashing broad credit concern. But when they diverge, it tells you something deeper: ➡️ CDX > I-Spread: synthetic markets are more risk-averse than the cash market — possibly signaling hedging activity or fear before it's priced into bonds. Less noise more signal. ➡️ I-Spread > CDX: cash bonds may be under pressure due to ETF outflows or idiosyncratic stress — technical selling, not systemic risk, may be driving the move. This can still be useful as you tells you to look for OTHER reasons why the ETF I-Spread diverges. This month's chart shows that the seas are calm in credit. Notice that spreads are near the bottom of the range for the month, likely a reflection of the subsidence of turmoil related to permanent tariffs. CDX tightening modestly while LQD’s I-Spread compressed even faster, suggesting ETF demand is absorbing credit risk more aggressively than the CDS market. 🧭 Interpretation: Cash is healing faster than CDS — perhaps a sign of yield-hungry investors stepping back into IG. All this is a signal of constructive credit sentiment — for now. 💡 For Fixed Income Investors Whether you're managing duration, evaluating risk-on/risk-off signals, or assessing dislocation opportunities — tracking both synthetic and cash credit spreads offers a fuller picture of the market's true credit tone. Nothing screams #activemanagement more than investing in credit. 📊 *FICM Chart sourced from Bloomberg #CreditMarkets #FixedIncome #ETFs #BondMarket #MarketSignals #InvestmentGrade #MacroRisk #SanJacAlpha #SpreadTrading #PortfolioInsights

An Overnight Index Swap (OIS) is a derivative that enables the periodic exchange of a fixed interest rate (for example, over 10 years) for a prevailing overnight rate (such as SOFR). Due to its daily settlement, OIS is effectively risk-free against counterparty risk. In contrast, the counterparty for a government bondholder is the issuing country. The ability to repay its debt depends on various factors that are not relevant to the OIS swap. This key difference makes it useful to compare the yield on government bonds with the equivalent OIS rate. The graph below illustrates this comparison on 10Y government bonds vs. equivalent OIS swaps for G5 currencies. Interpretation of the Spread 📈 Positive or Rising Spread (Tsy > OIS): This indicates that the central bank is engaging in quantitative tightening, which drives bond yields higher. 📉 Negative or Falling Spread (OIS > Tsy): This suggests increased demand for treasuries, potentially due to quantitative easing or regulatory requirements imposed on commercial banks to hold high-quality liquid assets. ⬅️➡️ Widening Spread (either positive or negative): A widening spread indicates tightening funding conditions and a potential inability of central bank rates to transmit effectively to the overnight swap market. Observations ⚖️ Countries with different regulatory frameworks tend to exhibit varying OIS-Treasury spreads at any given time, such as the comparison between USD and CHF below. 🔁Until around mid-2022, spreads across all G5 currencies were generally declining, a trend that has since reversed. 🪙 The USD and GBP structurally tend to have higher OIS-Treasury spreads compared to the EUR or CHF.

𝐁𝐥𝐚𝐦𝐞 𝐢𝐭 𝐨𝐧 𝐭𝐡𝐞 𝐩𝐞𝐧𝐬𝐢𝐨𝐧 𝐟𝐮𝐧𝐝𝐬! There has been an exceptionally sharp increase in ultra-long Japanese interest rates in recent weeks (40Y: +55 bp), significantly altering the return landscape for Japanese investors. The tables below show expected returns across JGBs, U.S. Treasuries, French government bonds, and Danish mortgage bonds from a Japanese investor's perspective. Previously, a JPY investor could expect a yield pick-up of around 40 basis points in the Danish callable bond 4% 2056 (callable) relative to the Japanese 10Y government bond (JGB), including roll. That is no longer the case: the spread has now narrowed to about 20 basis points. A similar pattern applies to French government bonds. A 20 bp expected excess return is not enough to justify exposure to foreign bonds, given all the risks this entails, and a sell-off of foreign bonds could be anticipated. Japanese investors hold large portfolios of U.S. Treasury bonds and also significant amounts in EUR government bonds from France, Italy, Spain, and Germany. While it would be analytically more accurate to compare the 4% 2056 with the 5Y JGB due to similar duration (and there is still a 1.26% extra pick-up in Danish callable bonds compared to the 5Y JGB), recent activity suggests that Japanese investors might be comparing Danish mortgage bonds with 10Y JGBs. The steeper JGB curve is driven by Japanese life insurance companies’ asset allocation. Historically, these insurers have had significant exposure to ultra-long-term JGBs and foreign bonds to match liability durations and achieve higher yields. However, they now appear to be retreating from these assets. According to several research reports, they have become net sellers of both ultra-long JGBs and foreign bonds. Meanwhile, a Dutch pension reform is also contributing to a steeper EUR yield curve, although not to the same extent as in Japan (EUR swap 30Y: +25 bp). The transition from defined benefit to defined contribution schemes is reducing the demand for long-duration hedging from Dutch pension funds — just as we see in Japan. Dutch pension funds have historically anchored the long end of the EUR swap curve. A similar shift from defined benefit to defined contribution occurred in Denmark almost a decade ago. On-the-run Danish mortgage bonds are not affected by the steeper curve, as callable annuity bonds do not have long curve exposure. However, there are some older low-coupon bonds (30-year 1%) that could be affected by higher 30-year yields. We estimate that Japanese investors currently hold only around DKK 30 bn in Danish callable bonds, and even though a sell-off in lower-coupon bonds will cause some market impact, the small market share should shield on-the-run bonds from any significant effect. Figure 1: Expected yearly return from a Japanese investor's perspective.

You're getting a debt quote for a $10,000,000 loan. Your debt broker says: "Rate is 5.5%." You say: "Great." And you move forward. But here's what you should ask: "What's the Treasury rate and what's your spread?" Your 5.5% rate is actually two pieces: → Base rate (Treasury): 4% → Credit spread (lender markup): 1.5% Combined = 5.5% Now here's where it gets interesting. The Fed cuts rates. Treasury drops to 3.75%. You think your new rate is 5.25%, right? Not always. The lender might widen their spread to 1.75% because of risk. Now your rate is still 5.5%. Nothing changed. OR If risk goes down (fewer deals failing, better economy), spreads might drop to 1.25%. Now your rate is 5%. That's a 0.5% difference. On $10,000,000, that's $50,000 per year in interest savings. Over 10 years? $500,000. And most syndicators have no idea this is happening. They just accept whatever quote they get. Here's what you should do: Ask your debt broker: "What's driving your spread? What would make it smaller? When do you expect it to move?" If they can't answer, find a better debt broker. Understanding credit spreads gives you power. You can time debt better. Negotiate better. Underwrite better. Who's actually explaining your debt pricing to you? P.S. If you want sharper underwriting going into 2026, we help sponsors and fund managers stress-test deals before capital goes out the door. Let's connect.

When the world is flooded with cheap money, many believe that asset classes such as equities, Gold, and real estate are expensive, but very few realize that debt is also very expensive and thus highly risky. Let me explain with a simple example. In a normal situation (no excesses on either side), a 10-year bond is available in the market with 6% coupon rate and a face value of 100. But when there is excess money in the system, chasing this bond, the price of the bond goes above 100 to 110. When someone purchases at 110, the net yield drops to 4.72%. Yield is inversely proportional to price. Excess money printing reduces the available yield on debt investments. Now, when that happens, investors want to look out for bonds with higher yields. In their desire to invest at higher yields, investors end up picking substandard debt papers. They forget that higher yields also come with higher risks. Risk that could not just impact interest payments but put the entire principal at risk. Many people are familiar with the risk of default in debt investments, but a very few understand credit spread risk. Credit spread is the difference between the yield of a corporate bond and a government bond. A bond of similar tenure and coupon payment schedule. The credit spread depends on the rating of the corporate bond. The lower the rating, the higher the credit spread over the Govt. bond of similar tenure and payment schedule. The credit spread is not static, and it changes with the investment scenario. When the investment community is very confident of the global outlook, the credit spread shrinks. Whereas, when there is fear regarding the future prospects, the credit spread expands. For example, in normal times, a 10-year AAA-rated bond will have a credit spread of 1.75% which could shrink to 0.90% when sentiments are highly optimistic and can expand to 2.70% when the sentiments are depressing. For BBB-rated bonds, the range could be wider depending on the market sentiment. So when the credit spread increases from 0.90% to 2.70%, the price of the bond goes down significantly, leading to severe mark-to-market losses. The extremes in the system can easily be understood when the market for unrated private credit has been expanding massively because investors want to chase higher yields while ignoring risks. These level of speculation most of the time leads to high losses and disappointment. If you are holding low-rated/no-rated Debt investments, it's high time you reevaluate your holdings and exit if you are not confident about the underlying business. Low/No-rated long-duration corporate debt papers should be avoided in an uncertain macro-environment. Always remember, when you invest in debt instruments, return of investment is more important than return on investment. And to ensure return of investment, one needs to understand the potential risks of such investments. Truemind Capital #debtinvestments #risks #truemindcapital

The most striking development in markets recently has been the rise in bond yields. Over the past year, 10-year yields in the US, UK, France, and Japan have climbed 60 to 120 basis points from their lows. What makes this particularly notable is that, aside from Japan, this has happened even as central banks have been cutting short-term policy rates. Bond yields can rise for various reasons. When central banks raise rates, as the Bank of Japan has, longer-term yields tend to rise in anticipation of higher short-term rates in the future. Yields can also rise with stronger economic growth, as markets expect central banks to tighten policy over time. Inflation expectations are another factor: when bond investors foresee higher inflation, they demand higher yields to compensate for the erosion of purchasing power. Indeed, rising inflation expectations explain part of the recent movement. However, the majority of the rise in yields is due to country-specific factors. In the UK, concerns about the sustainability of fiscal policy — amid weaker growth and persistent inflation — have pushed yields above levels seen during the “Truss moment” of September 2022. In France, political instability and challenges in passing a fiscally responsible budget have caused French bond yields to climb above even those of Spain. In the US, the rise in long-term yields has been driven by an increase in the term premium — the additional compensation investors require for holding longer-term bonds, reflecting greater uncertainty over time. Risks like inflation, interest rates, and liquidity are harder to predict over ten years than two, which increases this premium. Estimates suggest the term premium accounts for half to three-quarters of the recent increase in US long-term yields. This points to growing uncertainty about the longer-term economic outlook. In the US, questions loom over fiscal and trade policies, future inflation, and how much additional borrowing will be required to fund government spending. These uncertainties weigh on investor confidence and push yields higher. For now, bond yields haven’t risen to recent-year highs or in a disorderly manner, and they’ve even eased slightly with softer inflation data in the past week. Still, higher yields are beginning to pressure equity returns, much like they did in 2022, as higher rates reduce the present value of future cashflows. On the flip side, they also provide a stronger cushion if the economy or inflation slows more quickly than expected. All in all, an interesting start to the year.

You know it’s tight out there for a bond investor. The Bloomberg High Yield Index Option Adjusted Spread (OAS) over U.S. Treasuries has been at historic lows and decreased further on Friday. It is now 45 bps above the 30-year low for this index (reached in 2007) and is below the daily average for this year (see the chart below). These tighter spreads permeate the entire fixed income asset class and are not confined to one corner or another creating challenges for bond investors globally. Lower spreads are not necessarily a harbinger of bad things. These conditions can persist without any major crisis, especially if the technical and fundamental conditions for them exist and continue. Favorable macroeconomic conditions (per current market expectations), fiscal stimulus (continued tax cuts), lower default environment (thank you liability management), increased demand for bonds and lower bond supplies (as borrowers seek private bilateral credit relationships) all could support narrower spreads. Yet, the risks are to the downside. Tighter credit spreads mean that bonds are more likely to correlate to equities if a crisis or hiccup materializes – spreads could widen as equites go down. Narrower spreads also mean that bond prices cannot increase much from here lowering potential total returns unless spreads tighten more (unlikely). At the same time, investors are not being paid much above US government bonds. The bond portion of the 60-40 portfolio today is thus less effective (more correlation and downside risk) and less attractive (lower income and lower total return potential). What is an allocator to do? They can wait (hope?) for a better entry point, increase duration, invest in lower quality bonds or forgo liquidity. That is, chase yield. Or they may seek to manufacture yield and return through private and structured credit transactions. The increase in demand for private credit by allocators and investors is telling. But as basic private credit in the US and Europe becomes increasingly crowded and PE transactions (a driver of private credit) are taking longer to consummate, private credit writ large might begin to suffer diminishing returns and lower liquidity. Increased competition for a lower number of deals means that private credit funds are competing with each other for the same borrower and thereby compressing pricing and loosening covenants- not usually good for lenders. Complementing basic private credit allocations with credit strategies that are (i) decoupled from the capital markets, (ii) less dependent on financial engineering, and (iii) exhibit resilience even in downturns should help enhance portfolio and provide insurance against a credit downturn. We have health insurance, house insurance and car insurance. We might as well add portfolio insurance. PS: Not AI content. Not Investment advice.

The cost of funding for a AA-rated U.S. bank is closely linked to prevailing short-term interest rates and the bank’s specific funding mix. As of early 2025, average cost of funding (COF) for banks has plateaued, with recent industry averages ranging from about 2.5% to 3.5% depending on the size and structure of the institution. AA-rated banks, given their strong credit quality, typically secure funding at the lower end of this range, benefiting from investor confidence and lower risk premiums. However, the exact COF can vary based on deposit composition, market conditions, and competitive environment. The COF for an AA bank will generally track short-term rates with a lag of several months, and is usually about 0.5% to 1% lower than that of lower-rated peers due to their higher credit standing. Each notch downgrade from AAA typically increases funding costs by about 6 basis points (0.06%). For AA-rated banks, this means their funding cost is about 6 basis points higher than AAA, but still significantly below AA, A+, or lower-rated banks, where the interest penalty increases further with each lower rating notch. Over the last 100 days, the cost of funding and credit for AA-rated U.S. banks remain high, unrealized losses have increased with rate volatility, and tight spreads offer little cushion against risk due to persistent volatility + elevated credit risk, especially for lower-rated bonds. The outlook for the remaining 2025 is as follows: - Cost of Funding: Funding costs are expected to remain relatively high, as central banks are likely to keep interest rates “higher for longer” due to persistent inflation risks. There may be some volatility, but no significant decline in funding costs is anticipated in the near term. - Credit Risk and Default Risk: Credit fundamentals for investment-grade issuers remain stable, but there’s ongoing uncertainty in the macro environment. Default risks for high-yield bonds may rise slightly if economic growth slows, though strong corporate balance sheets are providing support for now. - Credit Spreads: Spreads are currently tight, reflecting strong demand and healthy issuer fundamentals. However, there is risk of spread widening if economic or policy shocks occur, which could lead to mark-to-market losses. Investors should be prepared for periods of volatility, especially given recent geopolitical and trade tensions. - Unrealized Losses/Mark-to-Market Risk: Interest rate volatility is expected to persist, impacting bond valuations. While yields remain attractive, price fluctuations could continue, especially if rate expectations shift or spreads widen. - Liquidity: Liquidity is expected to remain solid for investment-grade bonds due to ongoing strong demand, but could deteriorate quickly in risk-off episodes. - Operational and Regulatory Costs: These should remain stable, but ongoing uncertainty and volatility will require banks to maintain robust risk management and compliance efforts.