Why do spreads blow out all at once?

In a stressed week, something strange happens. Spreads widen on hundreds of issuers simultaneously — companies in unrelated industries, with unrelated balance sheets, that could not possibly have all deteriorated in the same five days. This co-movement is one of the defining features of credit, and it has several distinct causes worth separating.

Five reasons spreads move together

• One price of risk. Unit 1 showed that a large part of any spread is the risk premium, and the price of risk is set market-wide, not issuer by issuer. When investors collectively demand more compensation for uncertainty, every spread widens — even for issuers whose fundamentals are unchanged. This alone explains a great deal.
• Correlated fundamentals. A recession genuinely does hit many borrowers at once. Default correlation is why a portfolio of 200 names is far less diversified than it sounds: idiosyncratic risk diversifies away, but the common economic factor does not.
• Dealer capacity. Most corporate bonds trade over the counter through dealers who hold inventory. When balance sheet gets expensive or risk limits bind, that intermediation shrinks, bid-offer widens, and prices gap between trades rather than moving smoothly.
• Forced selling. Mandate limits, index rules, fund redemptions and margin calls all generate selling for reasons that have nothing to do with the bond being sold. The rating migration mechanic is one instance of a much broader phenomenon.
• Liquidity premium spikes. The liquidity component of the spread is smallest when markets are calm and largest exactly when everyone wants to sell. It is the least reliable part of the compensation — it is at its lowest precisely when you would most want to have been paid for it.

The arithmetic of a widening

You do not need a default to lose money in credit. Take an illustrative portfolio:

• Average spread duration: 5
• Average spread income: 300bp per year
• Market-wide spread widening over the year: 150bp

Then:

• Mark-to-market ≈ −5 × 1.50% = −7.5%
• Carry earned ≈ +3.0%
• Net ≈ −4.5%

Not one bond defaulted. Every coupon arrived. The portfolio still lost 4.5%, because the price at which risk trades changed.

What this means for diversification

The consequence is important and often learned expensively. Diversifying across issuers removes the idiosyncratic component of credit risk — the single-name blow-up. It does very little about the common factor, which is the one responsible for the large drawdowns.

So a credit portfolio's risk is dominated by a market-wide exposure that adding names does not reduce. Managing that is a different problem from picking credits, requiring different tools: spread duration, sizing, and instruments like the ones in the next lesson.

Reading co-movement honestly

When spreads widen together, the information content is about the price of risk, not about the issuers. When a single issuer's spread widens while its peers do not, that is issuer-specific information. Separating the two — how much of a move is market and how much is name — is the daily work of credit analysis.

As always: describing a move is analysis; extrapolating it is not. Nothing here forecasts direction.

Try it now

Decompose a move:

1. The New York Fed publishes a weekly distress index for investment-grade bonds and another for high yield, each running from 0 (calm) towards 1 (distress). Below are both across a stressed window, 21 February to 10 April 2020.

2. Note how closely they moved together: over how many weeks did each go from calm to distressed, and did either move without the other? Common movement across unrelated credits is the market factor doing its work.
3. The index is not in basis points, so read the same weeks in a price instead: a high-yield bond fund, full history. Measure its fall from the early-2020 high to the March low, treat the whole fall as spread widening, and back out the widening with price change ≈ − spread duration × spread change at a duration of 5. Compare that mark-to-market loss with a year of carry at an illustrative starting spread of 350bp. That comparison is why credit risk is measured in spread duration.