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Credit guys telling it like it isn't!!

For too long it seems too many credit strategists have not had to think too hard about the shape of yield curves. Now there is some funky stuff going on with term structure (curve shape), some strategists are putting out what I think might be unnecessarily risky trades. Why so? Taking more risk than you realise and need is dangerous.

In brief - interest rate risk (duration) and credit spread risk (duration) are not the same thing. Obvious but not a concern when both paid off for the past decade. Strategists telling a story of how great the dynamics are for buying corporate bonds in the middle of the yield curve are forgetting to tell you that most of those return dynamics are coming off the Treasury curve.

Steep interest rate curves basically remunerate a lender well for lending money over a longer period. When we lend in this fashion to the goverment we arrive at the government bond yield curve. We add a credit risk premium to this to arrive at the corporate credit yield curve, the rate we would charge to lend money to a less credit worthy borrower. But... and this is a big but... when the extra premium (spread) we charge to a corporate is the same regardless of term, we are not earning anything 'extra' for each year of credit risk we take on. We are just adding 'duration' because we want to take a bigger bet that we have lent money to a good guy. The incremental return is still coming from the steep underlying government bond curve. 

The basic conclusion is you may be buying more credit risk than you need. Buying government bonds in the middle of the yield curve because the rolldown dynamics are favourable is one thing... buying extra credit risk / spread duration you may not need because you apply the same thoughts to a corporate credit curve is another, especially if the spread curve is flat as it is now!

If someone knows better, please let me know, but for as long as we have steep interest rate curves and relatively flat credit spread curves, beware of how much risk on each you really want to buy.