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My apologies if this is not mathematical enough for this outlet.

My understanding of the pricing of a bond ETF is that lowering interest rates drive the price up and increased risk of default drives the price down. I'm trying to wrap my head around the dynamics of what happened to high yield corporate bonds around the great recession. Looking at a few of them, they lost in the neighborhood of 50% of their value at the bottom of the curve, which is about the same loss as the S&P 500.

During this period interest rates went from 5.2% to near 0%. Absent changes in default risk, this would imply that the price should have gone up. Obviously default risk went way up during the recession, but wouldn't this price change essentially mean that the market was pricing in a >50% chance of default for the underlying bonds? That seems to me to be curiously excessive even given the environment at the time. Was default risk the only thing driving the loss of value, or were there other factors in play?

Bonus question: How would the recession have affected an ETF with a fixed maturation timeline, such as iShares iBond? How would maturation date relative to the recession have played a role?

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During the recession, when rates fell towards zero, we're talking about Treasury yields. The yield of a high yield bond is comprised of the Treasury yield and credit spread so even though Treasury yields fell, the credit spread widened much more which is whe prices fell sharply.

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  • $\begingroup$ Thank you for taking the time to respond. Perhaps you could expand on this a bit. If the credit spread widens then absent default risk, wouldn't that make the underlying bonds more attractive (i.e. valuable)? That is unless the bonds were callable and called by the issuer. $\endgroup$
    – Ian Fellows
    Jul 14, 2019 at 5:49
  • $\begingroup$ Yes, it'll make it cheaper if it widens. You don't need default risk for credit spreads to widen. It could be concerns of a downgrade from ratings agencies or liquidity concerns from the company's ability to service debt. $\endgroup$
    – VanillaCall
    Jul 14, 2019 at 18:13

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