What is are “Credit Spreads”?
A credit spread is an analytical technique that allows investors to compare the yields of two different fixed income securities with the same or similar maturity. This is also known as “default spread” and compares the yield of a corporate bond against a risk-free alternative – usually the US Treasury note.
The main objective of credit spreads is to assess the additional return for the risk associated with the debt instrument. A widening spread is typically an indication for growing concern about the issuer’s ability to service its debt (hence investors require a higher yield to compensate for the risk), a narrowing spread signals the improving creditworthiness of the corporation as the default risk is decreasing.
Key Learning Points
- A credit spread is a difference in yield between a risk-free benchmark rate (usually a US Treasury note) and a corporate bond with a similar maturity.
- It is measured in basis points. 1% equals 100 basis points (or bps), so for example a difference of 0.82% will be expressed as 82 basis points.
- Credit spreads aim to assess the additional yield required to compensate investors for the risk associated with corporate debt security. Even high-quality corporates are considered riskier than US government bonds.
- Widening spread implies increasing default risk, where narrowing spread indicates decreasing risk. Investors often use credit spreads also as an indicator for the health of the economy.
- Generally, spreads are larger for bonds issued in emerging markets or by companies with lower credit ratings compared to those issued in developed markets or have a higher rating. For bonds with longer maturities, spreads are expected to be wider.
Credit Spread Fundamentals
When governments borrow money, they issue government bonds to investors and offer them a yield (or return) on their investment. The yield achieved on government bonds is low as their default risk is very low or non-existent.
On the other hand, corporate bonds offer a higher yield in order to compensate investors for the additional risk taken. The gap between the two yields is the credit spread and is measured in basis points, where 1% equals 100 basis points.
Credit Spread = Corporate Bond Yield – Benchmark Rate*
*Usually this is the US Treasury Bond Yield
Investors rely on credit spreads to judge the creditworthiness of the issuer and assess the risk and return associated with the bond. If the gap between the yield of the risk-free benchmark rate and the one offered by the corporate bond widen, this usually indicates an increased default risk and a higher return that compensates for that risk. The opposite is considered when the spread narrows as this indicates an improved ability of the issuer to repay its debt.
Company ABC has issued a corporate bond that matures in 10 years’ time and offers a 3.15% yield.
The yield of the 10-year US Treasury note is 1.63%.
The credit spread is 3.15% – 1.63% = 1.52% or 152 bps
Should the spread start to narrow and company ABC offers lower yield, that would signal its improved creditworthiness.
Other Factors That Can Influence Credit Spreads
The prevailing market environment, economic conditions, inflation, liquidity, or investor demand can all have a significant impact on credit spreads. Usually, uncertainty and worsening economic outlook would trigger a flight to safety and investors will seek to buy US Treasuries instead of corporate bonds.
Subsequently, the price of US Treasury bonds will increase and the value of corporate bonds will become less attractive and the yield they offer will rise which will increase credit spreads.