What Is a Credit Spread?
A credit spread is the difference between the yields of two bonds that offer the same coupon and have the same maturity. Since yield reflects the risk of a bond, the credit spread reflects the difference in the risk of two bonds with otherwise similar characteristics.
Usually, one of the bonds is issued by the U.S. Treasury, and so is considered to have no credit risk. In that case, the credit spread compares a “riskless” and a “risky” bond, and the spread itself can be thought of as the price of risk for a bond with that specific coupon and maturity.
A credit spread is typically quoted in basis points, where a basis point is 1/100th of 1%, or 0.0001.
How Do Credit Spreads Work?
When comparing the yield of a corporate bond to that of the perceived “risk free” U.S. Treasury in a vacuum, the higher the credit quality of the corporate bond, the narrower the spread will be.
Conversely, the lower the credit quality of the bond, the wider the spread. An unusually wide spread where there should be a relatively narrow spread could be an indication to an investor that there is some type of pricing inefficiency at play. The uncharacteristic spread could be indicative of value or pending risk that the market is not recognizing.
Credit Spread Example
Let’s assume a 20-year bond issued by Apple Computer (NASDAQ: AAPL) is yielding 2.52% versus the 20-year U.S. Treasury note yielding 2.42%. The credit spread would be just 10 basis points (bps); an extremely tight—almost nonexistent—credit spread. This would suggest that the risk of owning the Apple bond is equivalent to that of holding the U.S. Treasury bond.
The different scenario would be comparing the same Treasury to a 20-year Netflix (NASDAQ: NFLX) bond yielding 6.12%. The credit spread would be 370 bps (3.70%), reflecting much more risk in owning the Netflix bond.
What Does it Mean When Credit Spreads Widen (Tighten)?
When credit spreads widen, there is a bigger difference between the yield for a risky, corporate bond and the yield of a comparable, riskless government bond. That means that the price of risk has increased. It is usually taken as a signal that there is more volatility in the bond markets, and/or more unease about the economy and about companies’ ability to pay debts.
Likewise, when spreads tighten, it implies that there is less concern about economic disturbances that would disrupt companies’ ability to pay off debts (like bonds).
For this reason, credit spreads are often used as a barometer for economic and market conditions. If spreads narrow, market and economic conditions are seen as encouraging and there is less perceived risk in the investing marketplace. If credit spreads are widening, economic conditions in the business sector may be deteriorating and market risk may be growing.
