Credit spread
Yield difference between a corporate bond and a risk-free asset of the same maturity, jointly remunerating expected default, downgrade risk, and illiquidity.
A credit spread is the difference between a security's yield and that of a supposedly risk-free asset of the same maturity and currency. Its decomposition is the central point for an insurer, because each component is handled differently. The expected default share is a statistical loss that must be provided for. The downgrade share remunerates the risk of being forced to sell after a rating cut, a constraint that binds a manager with a minimum rating mandate and not a hold-to-maturity investor. The illiquidity share remunerates the inability to sell fast without a price concession, and it is the only one an insurer with predictable liabilities gets to keep, since it will never be forced to sell. Two empirical properties matter. Spreads widen far faster than they tighten, which produces an asymmetric distribution poorly represented by a standard deviation. And they correlate strongly across issuers in stressed periods, which cancels bond diversification at the exact moment it would be useful.
European investment grade corporate spreads widened by several hundred basis points within weeks in March 2020, then took more than a year to return to earlier levels. An insurer holding to maturity suffered no permanent loss from it. Its solvency ratio still fell at the quarterly closing, which is exactly the mismatch the volatility adjustment seeks to damp.
Follow the research
One letter a week. First, the week's underwriting note, when one is published: a dated, argued decision, signed by Paul Bernardski. Then what the observatory published on cyber risk, political risk and insurance. No account, no tracking.
No spam, one-click unsubscribe, no data ever sold.