Normally, longer-term corporate bonds command higher risk premiums as compensation for the increased uncertainty. In times of stress or crisis, however, this can temporarily reverse, and shorter-term bonds may exhibit comparable or even higher spreads!
Upward-Sloping Spread Curves
This is because a bond’s risk premium is intended to compensate the investor for the default risk over the bond’s entire term. Therefore, a potential deterioration in credit quality over time must also be taken into account. However, the further into the future one tries to forecast the development of credit quality, the more difficult and uncertain the result becomes.
In the short term, a company’s credit quality should not change significantly, and the probability of default can be assessed relatively well (lower debt repayments, good liquidity, an established market position, and existing customer relationships).
Over a 5- or 10-year horizon, however, a great deal can happen (new competitors, regulatory changes, shifts in customer preferences, etc.), and the question of repayment becomes significantly more difficult to answer. To account for this increasing uncertainty regarding bond repayment, investors generally expect a higher risk premium for longer maturities from the same issuer.
This phenomenon can be observed in the spread curves of individual issuers, as well as in aggregate at the index level. For example, the current spread curve of the European high-yield market shows a slightly positive slope (see figure).
Flat and Inverted Spread Curves
This occurs when the short-term default risk is viewed as particularly high due to acute problems or market disruptions. Thus, in the case of an inverted spread curve, investors expect a high short-term default risk, but anticipate a subsequent decline to more normal levels (provided the company remains in business).
For the overall market, this phenomenon can be observed during an external shock or major economic disruptions (e.g., the 2008–2009 financial crisis, the 2020 COVID-19 pandemic, or the 2022 rise in interest rates).
Risk Premiums by Maturity Band
Certain Default
In this case, bonds of all maturities will trade at the same price level—the level of expected recovery. However, due to the shorter duration of short-term bonds, they will mathematically exhibit a significantly higher spread than longer-term bonds trading at the same price.
Risk Premiums by Maturity Band (Issuer with Very High Default Risk)
Opportunities Presented by an Inverted Spread Curve?
There is no simple, blanket answer to this question. If the inverted spread curve persists for a longer period—which, however, is rather rare—a short-term bond with a higher yield can, of course, deliver better performance.
However, if market stress subsides and the spread curve normalizes (no longer inverted and at a generally lower level), longer-term bonds may have an advantage due to their higher duration, even if they experience a smaller overall narrowing of the spread than short-term bonds.
Roll-Down
For example, if one invests in a bond issued by an issuer whose credit profile remains relatively stable, the bond’s risk premium should decrease as its remaining maturity declines. This allows investors to generate not only yield but also price gains from the narrowing of the spread.
Conclusion:
These various patterns offer experienced investors the opportunity to generate attractive returns. For this reason, it is advisable to entrust investments in corporate bonds in general—and high-yield bonds in particular—to a proven fixed-income credit specialist.
At HAGIM, we consider ourselves well-equipped to meet such challenges thanks to our investment philosophy, which is based on in-depth fundamental credit analysis.
Risks
Price losses due to increases in yields and/or higher risk premiums are possible. A total loss cannot be ruled out either. Past performance is not indicative of future results, nor can future performance be guaranteed.
Disclaimer
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