The economic factors that influence corporate bond yields are interest rates, inflation, the yield curve, and economic growth. Corporate bond yields are also influenced by a company's own metrics such as credit rating and industry sector. All of these factors affect corporate bond yields and exert influence on each other.
The pricing of corporate bond yields is a multivariate, dynamic process in which there are always competing pressures.
- Corporate bond yields indicate the relative riskiness of the issuing company but are also influenced by macroeconomic factors.
- Economic growth and low inflation are positive for corporations, and so they have a downward effect on bond yields.
- When economies grow, however, target interest rates may be increased as inflation rises, which puts positive pressure on yields.
Economic growth, typically measured by a rising GDP, is bullish for corporations as it leads to increased revenues and profits for companies, making it easier for them to borrow money and service debt, which leads to a reduced risk of default and, in turn, lower yields.
However, extended periods of economic growth lead to inflation risk and upward pressure on wages. Economic growth leads to increased competition for labor and diminished excess capacity.
Higher wages due to inflation begin to eat away at profit margins, making them more vulnerable to slippage in economic growth. Inflation also raises the prices of things in the economy in general terms, and as things become more pricey the ability to pay for them rises, and so credit risk increases—a positive pressure on yields.
Inflation risk also leads central banks to raise target interest rates. When the risk-free rate of return rises, corporate bond yields must rise as well to compensate. The higher yields add to increased costs, creating even more vulnerability to economic stumbles.
Thus, yields can skyrocket as costs mount if the economy slips into a recession and revenues fall; investors begin to price in an increased chance of default. When growth concerns begin to dwarf inflationary risks, the central bank cuts interest rates, leading to downward pressure on corporate bond yields. Decreases in the risk-free rate of return make all yield-generating instruments more attractive.
Credit risk (i.e. the risk of default) is a company-specific factor, not necessarily a macroeconomic one. Still, the factors above feed directly into a company's ability to repay its debts and obligations. Credit ratings published by agencies such as Moody's, Standard and Poor's, and Fitch are meant to capture and categorize credit risk. However, institutional investors in corporate bonds often supplement these agency ratings with their own credit analysis.
Many tools can be used to analyze and assess credit risk, but two traditional metrics are interest-coverage ratios and capitalization ratios. Issuers with higher credit risk will have corporate bonds with higher interest rates to compensate for the additional risk.
The Bottom Line
The most bullish scenarios for corporate bonds are economic growth due to an increase in productivity, which does not spark inflation. In contrast, the most bearish scenario is a weak economy with inflationary risks that lead to high-interest rates.