Risk Premium on Corporate Bonds

[Wallabyboy]

My question relates to Lesson 16 “Capital Market Expectations”, Practice Problems, question 16.

I don´t know if I fully agree with the rationale used by CFA Curriculum. The question is how does a change in the 1y forecast of certain variables (GDP, Central Bank Money Supply, Government Spending vs. Tax Receipts) affect the Corporate Fixed-Income Market, justify it in terms of the likely risk premium impact.

• GDP is forecasted to grow by 9%: CFA states that this is going to have a negative impact on the Corporate Fixed-Income market since " such a strong economy would be a negative for corporate bond investors in that such economic growth and aggregate demand would place upward pressure on bond yields. In addition, in time, expectations of rising inflation could also hurt corporate bond investors".

I mean, ok, higher expected inflation could eventually lead to interest rate increases but how is it argued that the impact is mostly negative? Couldn´t it be argued that stronger economic growth would help equities, and would help reduce the spread of corporate bonds? Also, could anyone let help me with the rationale for the sentence “economic growth and aggregate demand would place upward pressure on bond yields”? Is that that higher expected growth would be tamed by Central Banks by increasing rates in order to avoid the economy from overheating and inflation from increasing too much? Or is it something else?

Additionally, I would also argue that higher growth, would make investors more likely to buy equities, flying away from Fixed Income, lowering demand and thus increasing yields.

• With regards to Central Bank Money Supply, which is also forecasted to increase, CFA says that such growth would likely have a negative impact on Corp Fixed-Income market. Argument used is the same "bond yields could be expected to increase because monetary stimulation may increase expectations for higher aggregate growth and because of the potential higher inflation that monetary stimulation can cause over time ". I don´t fully follow the line of argument here, seems to me there are other factors that would drive bond yields in different direction.

Thank you very much!

[CEO10K-DAY]

@Wallabyboy

I mean, ok, higher expected inflation could eventually lead to interest rate increases but how is it argued that the impact is mostly negative? Couldn´t it be argued that stronger economic growth would help equities, and would help reduce the spread of corporate bonds? Also, could anyone let help me with the rationale for the sentence “economic growth and aggregate demand would place upward pressure on bond yields”? Is that that higher expected growth would be tamed by Central Banks by increasing rates in order to avoid the economy from overheating and inflation from increasing too much? Or is it something elsee

Stronger economy --> stronger earnings. Investors flock to stocks and leave bonds --> bond prices fall, yields rise.

Remember that a bond investor must be compensated for:

1. Risk free rate 2. Inflation premiu 3. Credit risk 4. Liquidy risk 5. Maturity risk 5.5 Tax risk

The inflation premium is rising faster than the credit risk is falling. Credit spreads may narrow - but this is ultimately trumped by the other factors that ultimately effect yield.

Would appreciate others to chime in too.