- Individual corporate-bond yields are expected to be close to the issuer’s yield curve. Deviations can be interpreted as mispricing relative to other bonds from the same issuer.
- Investors looking to trade corporate bonds may find that bid-ask (used in isolation) understated actual market liquidity after the onset of the COVID-19 pandemic.
- Credit investors may look to the deviation of bond yields from the curve as an additional liquidity signal beyond bid-ask spread, and as a measure of relative value.
A corporate bond’s yield curve is similar to the well-known Treasury yield curve. It provides a theoretical yield of a par or zero-coupon bond at any time to maturity. A well-constructed yield curve provides a consistent view of the price of an issuer’s credit.1 An individual bond’s yield may deviate to some degree from the theoretical yield, however. If two otherwise similar bonds differ significantly, this may indicate that the bond prices are not consistent, which may be a sign of mispricing. As such, the deviation of a corporate bond’s yield from the yield curve, or mispricing spread, may be a useful signal into the fundamental or systematic credit-investment process.
Corporate-bond mispricing has remained elevated since the start of the pandemic
Unlike more common measures of liquidity like bid-ask spread, mispricing spread has remained elevated relative to pre-COVID-19 levels. The overall amount of mispricing can be measured using the yield dispersion, which is the median absolute mispricing spread over a universe of bonds. The exhibit below shows the yield dispersion for the USD investment-grade corporate universe.
Bond-yield dispersion spiked with bid-ask spread, but has remained elevated
Median spread difference, measured in basis points (bps), between the theoretical price implied by the yield curve and quoted bond prices (left); median bid-ask spread (in bps; right). Source: S&P Global, MSCI USD IG Corporate Bond Index
Mispricing at the issuer level
A key difference between bid-ask spread and mispricing spread is that the mispricing spread can be positive or negative and for that reason indicates the potential direction of mispricing. So in addition to being an alternate measure of liquidity, the mispricing spread can be used to highlight bonds that are cheap or rich relative to the curve. The exhibit below shows the mispricing spreads for a set of bonds from four financial issuers. A large number of positive and negative mispricing spread emerged during the peak of the COVID-19 market dislocation — and subsequently reverted. In addition, in recent months we have seen significant mispricing spreads.
Deviations from the yield curve may indicate bond mispricing
Individual bond-spread difference (in bps) between the theoretical price implied by the yield curve and quoted bond prices for specific issuers.
Mispricing spread and bond selection
Mispricing spread complements fundamental valuations and proprietary signals because it is a pure measure of price consistency, based only on market prices and basic assumptions about the shape of the yield curve. Therefore, the mispricing spread may add value when used in conjunction with other valuation signals as an input in bond selection.
The author would like to thank Dimitrios Karkantzos for his contribution to this blog post.
1We use multiple bonds from an issuer and create a curve designed to minimize differences between the curve and individual bonds.
Further Reading
MSCI Corporate and Sovereign Issuer Curves
MSCI Credit Curves (client access only)
Was the Treasury Price Right? Yield Dispersion Amid COVID-19