Credit Spread , Formula, & Examples

What is a Credit Spread?

A credit spread is the difference in yield between a U.S. Treasury bond and another debt security of the same maturity but different credit quality. Credit spreads between U.S. Treasuries and other bond issuances are measured in basis points, with a 1% difference in yield equal to a spread of 100 basis points. As an example, a 10-year Treasury note with a yield of 5% and a 10-year corporate bond with a yield of 7% are said to have a credit spread of 200 basis points. Credit spreads are also referred to as "bond spreads" or "default spreads." Credit spread allows a comparison between a corporate bond and a risk-free alternative.

A credit spread can also refer to an options strategy where a high premium option is written and a low premium option is bought on the same underlying security. This provides a credit to the account of the person making the two trades.

Understanding Credit Spreads (bonds and options)

Credit Spread for Bonds

A bond credit spread reflects the difference in yield between a treasury and corporate bond of the same maturity. Debt issued by the United States Treasury is used as the benchmark in the financial industry due to its risk-free status being backed by the full faith and credit of the U.S. government. US Treasury (government-issued) bonds are considered to be the closest thing to a risk-free investment, as the probability of default is almost non-existent. Investors have the utmost confidence in getting repaid.

Corporate bonds, even for the most stable and highly-rated companies, are considered to be riskier investments for which the investor demands compensation. This compensation is the credit spread. To illustrate, if a 10-year Treasury note has a yield of 2.54% while a 10-year corporate bond has a yield of 4.60%, then the corporate bond offers a spread of 206 basis points over the Treasury note.

Credit Spread (bond) = (1 – Recovery Rate) * (Default Probability)

Credit spreads vary from one security to another based on the credit rating of the issuer of the bond. Higher quality bonds, which have less chance of the issuer defaulting, can offer lower interest rates. Lower quality bonds, with a higher chance of the issuer defaulting, need to offer higher rates to attract investors to the riskier investment. Credit spreads fluctuations are commonly due to changes in economic conditions (inflation), changes in liquidity, and demand for investment within particular markets.

For example, when faced with uncertain to worsening economic conditions investors tend to flee to the safety of U.S. Treasuries (buying) often at the expense of corporate bonds (selling). This dynamic causes US treasury prices to rise and yields to fall while corporate bond prices fall and yields rise. The widening is reflective of investor concern. This is why credit spreads are often a good barometer of economic health - widening (bad) and narrowing (good).

There are a number of bond market indexes that investors and financial experts use to track the yields and credit spreads of different types of debt, with maturities ranging from three months to 30 years. Some of the most important indexes include High Yield and Investment Grade U.S. Corporate Debt, mortgage-backed securities, tax-exempt municipal bonds, and government bonds.

Credit spreads are larger for debt issued by emerging markets and lower-rated corporations than by government agencies and wealthier and/or stable nations. Spreads are larger for bonds with longer maturities.

Credit Spreads as an Options Strategy

A credit spread can also refer to a type of options strategy where the trader buys and sells options of same type and expiration but with different strike prices. The premiums received should be greater than the premiums paid resulting in a net credit for the trader. The net credit is the maximum profit that trader can make. Two such strategies are the bull put spread, where the trader expects the underlying security to go up, and the bear call spread, where the trader expects the underlying security to go down.

An example of a bear call spread would be buying a January 50 call on ABC for $2, and writing a January 45 call on ABC for $5. The trader's account nets $3 per share (with each contract representing 100 shares) as he receives the $5 premium for writing the January 45 call while paying $2 for buying the January 50 call. If the price of the underlying security is at or below $45 when the options expire then the trader has made a profit. This can also be called a "credit spread option" or a "credit risk option."