Credit Spread

What Is Bond Credit Spread?

Bond credit spread (instead of options credit spread) indicates the different yields of two bonds with a similar maturity but different credit ratings. Put another way, bond credit spread measures the difference in returns between two bonds due to disparate risk levels.
You might think, "I don't invest in bonds. For what reason would it be advisable for me I care about bond credit spread?" One explanation is that bond credit spreads can be a leading indicator of the overall economic environment. Bond credit spread likewise is a high-level risk analysis of the borrower (the bond issuer), so investors can utilize bond credit spread as one marker of an issuer's or an industry's creditworthiness.

Key Takeaways

Bond credit spread is a snapshot of the different yields between a Treasury bond (T-bond) and a corporate bond or municipal bond of the equivalent (or comparable) maturity.
By and large, the higher the spread, the riskier the corporate or municipal bond.
Any remaining factors being equivalent, shorter-dated bonds have narrower credit spreads since default risk increments with longer terms.
Bond credit spreads move continuously, just like stock prices.
A narrowing bond credit spread can point to working on economic conditions and lower overall risk.
An extending bond credit spread typically suggests deteriorating economic conditions and higher overall risk.

Instructions to Calculate Bond Credit Spread

Utilize the following equation to calculate a bond credit spread:

Credit spread = corporate bond yield - Treasury bond yield

A few investors substitute a benchmark bond yield of their decision in place of the Treasury bond yield. In that case, you would utilize the following equation instead:

Credit spread = corporate bond yield - benchmark bond yield

Is Options Credit Spread the Same Thing as Bond Credit Spread?

Credit spread can allude either to an options investing strategy or to bonds, and these are two altogether different things. The following terms are completely related to options strategies:

Debit spread
Credit put spread
Credit call spread
Iron butterfly ("In-a-Gadda-Da-Vida," anybody?)
Iron condor
Short butterfly
Short condor

This article centers exclusively around bond credit spread, which is sometimes called the yield spread.

Bond Credit Spread Example

Let's consider bond credit spread as exemplified by two hypothetical bonds from different issuers. First, we have a 10-year Treasury note (T-note) issued by the U.S. federal government. The subsequent bond is a 10-year Alphabet (corporate) bond. All conversations of bond credit spread accept the yield-to-maturity (YTM), which is often alluded to just as the yield.
The hypothetical yield, or interest rate, of the 10-year T-note is 1.54%, and the hypothetical yield of the 10-year Alphabet bond is 3.60%. In this model the Alphabet bond offers a 2.06% spread over the T-note:

3.60% - 1.54% = 2.06%

The credit spread can likewise be alluded to as a 206-premise point risk premium.
A government bond, for example, the T-note is frequently utilized as the benchmark rate on the grounds that U.S. Treasury bonds are viewed as the closest thing to a risk-free investment, with an almost nonexistent probability of default. The bond credit spread quantifies the additional risk lenders take on when they buy corporate debt (bonds) versus government debt (bonds) of the equivalent or comparative maturity.

What Is a Normal Bond Credit Spread?

Historically, 2% is the average credit spread between 2-year BBB-rated corporate bonds (see below for more about bond credit ratings) and 2-year U.S. Treasuries. In any case, economic conditions presently change so rapidly that an average credit spread might be a thing of the past. Dive into different statistics and charts related to the bond credit spread (both current and historical) at the FRED online database from the Federal Reserve Bank of St. Louis.

What Does Bond Credit Spread Indicate About Market Conditions?

Bond credit spread can be a bellwether of overall economic conditions. Changes in bond credit spread can suggest the following:

Changing perceptions of default risk by a specific bond issuer
Changing perceptions of general market conditions
Both of the abovementioned

Let's say the market turns out to be more skeptical about the creditworthiness of fictional giving company Wheels-R-We (a traditional automaker that produces internal combustion cars). Consequently, the spread increments, or broadens, for Wheels-R-We bonds. This means the yield (the interest rate) gets pushed higher for Wheels-R-We bonds relative to the benchmark yield. In the event that markets overall become more negative and risk-unwilling, bond credit spreads overall tend to enlarge.
But in the event that sentiment improves toward either Wheels-R-We or the overall auto industry, the relevant credit spreads would fall, or narrow. In this case, the yield declines for Wheels-R-We bonds. Narrowing credit spreads can indicate working on private (corporate or municipal) creditworthiness alongside overall economic growth.

For what reason Do Bonds Have Credit Ratings?

Anytime you loan money, you're accepting the risk that the borrower will default, or fail to pay back the loan in full. Every specific bond's credit rating partially quantifies that risk of default.
On the off chance that you purchase a bond, you're loaning money to the bond issuer. With a Treasury bond (T-bond), you're loaning money to Uncle Sam; with a Miami municipal bond, you're loaning to the City of Miami; with a Ford corporate bond, you're loaning to Ford Motor Company. Each bond issuer (a borrower) gets a credit rating from either Moody's or Standard and Poor's (S&P). For Moody's credit rating table, allude to this PDF; S&P makes sense of its rating interaction here.
The highest credit rating is Aaa/AAA (Moody's/S&P), and the lowest credit rating is Caa3/D. Credit ratings are additionally split into two gatherings: investment grade and non-investment grade (or "high yield"). At last, each separate bond issue is individually rated. Individual rating means bonds issued by a similar organization but at different times or with different maturities can have different credit ratings.
Bond investors utilize the credit spread to gauge the risk of default against the potential reward of a bond's yield. Other factors that affect the risk of default incorporate the broad economic environment and the stability or instability of the bond issuer's industry — for instance, the traditional auto industry during the period of expanding "green" regulations with respect to electric cars.

Could Credit Spread Be Negative?

A negative bond credit spread can be a harbinger of specific economic changes. During the mid 21st century, scholastics and practitioners introduced several statistical pricing models for bond credit spread. Business analytics firm Dun and Bradstreet distributed one extensive analysis of such models that incorporates information about negative bond credit spread.

Highlights

A credit spread options strategy ought to result in a net credit, which is the maximum profit the trader can make.
A credit spread reflects the difference in yield between a treasury and corporate bond of a similar maturity.
A credit spread can likewise allude to an options strategy where a high premium option is written and a low premium option is bought on a similar underlying security.
Bond credit spreads are often a decent barometer of economic health - broadening (terrible) and narrowing (great).