what is quality spread? please, someone, meaning, example, decrease

Kapie

what is quality spread?
There is an example in LOS 66j , that explains the stock return using multifactor model.It says, apart from other things, that a decrease in quality spread is good news for stock MT.

I looked up the meaning of quality spread ( Credit spread) but am confused as to how does reduction in quality spread is a good news for a stock and vice versa. Can someone please help me with an example here?

Thanks

tarunajwani

Thanks cp and eastCoastJ
You both were right on the money for me.
thanks a lot

b_sea93

CPK: You're still with us L2'ers?

kkn006

nope am in L3 -- just keep visiting.. earned my visitation rights!

CP

giorgio10

You did indeed...

tobeornottobe

you need to pay less of a spread (difference in rates) for the quality difference between this stock and some other stock. Less Spread is usually better.

rate at which you discount the cash flows is affected by the spreads..

so if a lower spread is attached to a stock - it will be discounted at a lower rate - and when that happens - value goes up.

CP

chaojimali

Decreasing quality spreads sounds like a bad thing, but it is actually a good thing for the company you are valuing. The quality (credit) spread decreasing tells you corporate yields are going down from investors bidding up corporate bonds. and comparable government yields are increasing and treasury prices falling due to investors moving money into riskier assets.

Basically investors who would only borrow from a BBB rated corporation for 10 YR at 5% before are now comfortable borrowing at 4%.

If you remember from the Bond Yield + Premium approach of equity valuation, you will recall that required return assumptions on an equity can be made by just tacking on equity risk premium to the yield of your corporate bonds. So anytime the quality spread decreases, your bond yield goes down, and required return goes down too as there is less risk. Your discount rate goes down, so your valuation goes up.



Edited 1 time(s). Last edit at Saturday, February 5, 2011 at 11:12PM by EastCoastJ.