How Lower Interest Rates Can Narrow Corporate Credit Spreads

Summary

The document explains a portfolio-search mechanism linking lower policy rates to tighter corporate bond spreads. When deposit and money market yields fall, investors seeking income may move farther along the yield curve and accept more credit risk. Increased demand for riskier bonds raises their prices and lowers their yields relative to safer securities, narrowing spreads even if company credit ratings have not changed.

The explanation is qualitative and gives no data or empirical test of the relationship. It describes a possible market-wide response to changing returns, rather than a change in an issuer’s creditworthiness. Investor objectives and risk appetite vary, and lower rates do not guarantee that investors will buy riskier debt or that spreads will contract; the passage offers no timing, magnitude, or conditions for the effect.

Key ideas

• Falling deposit and money market yields can prompt investors to seek income in longer-term securities.
• Investors seeking yield may accept more credit risk when safer instruments pay less.
• Greater demand for corporate bonds can lift their prices and narrow their yield spreads.
• Spread compression can occur without a change in an issuer’s credit rating.
• The passage offers a qualitative mechanism, not evidence that the effect always occurs.

Tags

# Relation between low rate and credit risk


# Relation between low rate and credit risk












In the Handbook of Fixed Incomes Securities, there is this part:

> The lower federal funds rate prods banks to be less aggressive in issuing deposits, such as certificates of deposits (CDs). Their rates drop, bringing down other money market interest rates which compete with CDs and other bank deposits. Investors, now searching for higher rates, extend along the yield-curve. This pushes longer-term rates lower. Furthermore, with interest rates having fallen, investors maybe more willing to accept credit risk as they seek to replace yield in their portfolios. Risk spreads on corporate bonds narrow.

I don't understand why lower rates will change investors mind if credit ratings of companies didn't change ?

## Answer by Jake Freeman (score 2, accepted)

https://quant.stackexchange.com/a/47324

As Federal interest rates decrease people who want to get yield are required to take on more risk. Thus they bid up more risky assets which decrease their yield and subsequent spreads. When rates are higher people get more yield from less risky instruments so they sell the more risky. The reason why people want higher yield is for retirement, investors, etc.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.