What Is a Credit Spread?
Credit spreads are an important concept in both bond investing and options trading. In the bond market, they can show how risky different bonds are and provide insights into the economy's health. This article breaks down what credit spreads are, how they work, and why they matter. We'll first discuss credit spreads in the context of bonds and then briefly explore the concept in options trading.
What Are Credit Spreads?
A credit spread is the difference in returns between two loans or bonds that will be paid back at the same time but have different credit ratings (risk levels).
In bond trading, the concept relates to comparing two bonds that mature at the same time, one from a safer borrower and one from a riskier one (such as debt issued by emerging markets or lower-rated businesses).
The credit spread shows how much more return the riskier bond offers to make up for the extra risk. Unsurprisingly, this difference can affect how much you earn on your investment.
How Credit Spreads Work
Typically, investors compare the yield of a corporate bond with that of a government bond, such as a US Treasury note, which is considered low-risk. For example, if a 10-year US Treasury bond yields 3% and a 10-year corporate bond yields 5%, the credit spread is 2% or 200 basis points.
Many investors use credit spreads to understand not only how risky a single company’s bond is but also how healthy the overall economy is. When credit spreads are wide, it often signals economic trouble. When they’re narrow, it suggests confidence in the economy.