Credit Spread: What It Means for Bonds and Options Strategy

Savvy investors recognize that credit spreads are among the best indicators of the broader economy's health, not just the creditworthiness of individual companies. In bond trading, a credit spread is the difference between the yields of two bonds with the same maturity but different credit quality. This spread can have a significant impact on your investment returns. 

Credit spreads are measured in basis points, where one basis point equals 0.01%. For example, a 1% difference in yield is equal to a spread of 100 basis points. Also known as bond, yield, or default spreads, they allow you to quickly compare the yields of corporate bonds to risk-free alternatives, such as Treasury notes. For instance, if a 10-year Treasury note yields 5% and a 10-year corporate bond yields 7%, the credit spread between the two bonds is 2%, or 200 basis points. Analysts also use the spreads to assess the broader economic climate by aggregating all corporate bonds of a particular type and subtracting the Treasury rates. Wider yields portend a dire outlook, while narrowing yields indicate economic optimism.

It's worth mentioning that ‘credit spreads’ also refers to an options trading strategy. In this context, a credit spread involves writing a high premium option and buying a low premium option on the same underlying asset, resulting in a net credit to the trader’s account.

Below, we’ll explain how to calculate credit spreads and discuss their importance in investing.

Bond Credit Spreads

A bond credit spread, also known as a yield spread, is the difference in yield between two bonds with similar maturities but different credit qualities. It is a measure of the additional yield that investors demand for holding a bond with a higher perceived credit risk than a safer bond, such as a government bond or a high-quality (AAA-rated) corporate bond over a junk bond.

The bond credit spread is typically given in basis points (bps), where 1 bp equals 0.01%. For instance, if Bond A has a yield of 5% and Bond B has a yield of 4%, the credit spread between them is 100 bps, or 1%.

Bond credit spreads are often used to gauge the market's perception of the creditworthiness of a particular issuer or sector. A wider credit spread means that investors perceive a higher risk of default and require a higher yield to compensate for that risk. Conversely, a narrower credit spread suggests that investors are more confident in the issuer's ability to meet its debt obligations and are willing to accept a lower yield.

Here are a few examples of bond credit spreads:

• Corporate bond spread: The difference between a corporate bond yield and a government bond with a similar maturity. This spread reflects the additional credit risk associated with particular corporate issuers.
• Emerging market bond spread: The difference between the yield of an emerging market bond and a developed market bond with a similar maturity. This spread reflects the added risks of investing in certain emerging market economies, such as political instability, currency fluctuations, and less developed financial markets.
• High-yield spread: The difference between a high-yield (junk) bond yield and a government bond with a similar maturity. This spread is generally wider than investment-grade corporate bond spreads because of the greater credit risk.

Investors, analysts, and policymakers closely monitor bond credit spreads since they provide valuable insights into market sentiment, risk perception, and the overall health of the bond market. Changes in credit spreads also have implications for borrowing costs, investment strategies, and economic growth.

Interpreting Bond Yield Spreads for Economic Health

The yield spread between corporate bonds and 10-year Treasury bonds has long been considered a crucial indicator of economic conditions and investor sentiment. Yield spreads reflect the risk premium, or additional compensation, investors require for taking on the risk of corporate bonds over the relatively risk-free Treasurys.

In typical economic conditions, the spread between high-quality corporate bonds (such as those rated AAA) and 10-year Treasurys typically ranges from 1% to 2%. For lower-quality corporate bonds (such as BBB-rated bonds), the spread is usually higher, ranging from 2% to 4% or more. These spreads provide greater insight into investor sentiment about the economy than many other economic indicators.

Interpreting Yield Spreads

A narrow yield spread, close to 1%, suggests that investors are confident in the economic outlook and believe that the risk of corporate defaults is low. This scenario is common during strong economic conditions, where investors are willing to accept lower premiums for holding corporate debt.

Meanwhile, a widening yield spread indicates increased concern about the economy. As investors become more risk-averse, they demand higher yields on corporate bonds to compensate for the perceived higher default risks (the weaker the broader economy is, the more companies are likely to struggle with meeting their obligations).

As you can see from the chart below, widening spreads signal economic uncertainty, potential downturns, or significant crises, such as the bond yield spread spikes following the events of September 11, 2001, the 2007-2008 financial crisis, and the pandemic. These events were marked by considerable economic jitters, if not panic, affecting the bond markets and beyond. Conversely, yield spreads that move closer to and below 1.0% indicate greater confidence in the broader economy.

Yield Spread Formula

The credit spread of a bond is a measure of the additional yield that investors demand for holding a bond with a higher credit risk. It can be approximated using the formula:

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

In this formula, the recovery rate represents the percentage of the investment that investors expect to recover in the event of a default, while the default probability represents the likelihood of the issuer not meeting its debt obligations. The term (1 – Recovery Rate) represents the expected loss given default, which is then multiplied by the probability of default to estimate the overall expected loss for the bond.

The expected loss serves as a proxy for the credit spread, as investors would require a higher yield to compensate for the potential loss. However, this formula is a simplification and doesn't account for all the factors that influence credit spreads, such as liquidity risk, market sentiment, and the specific cash flow characteristics of the bond.

Calculating a Credit Spread Between Bonds and Treasurys

A credit spread is the measure of the  difference in yield between a Treasury and corporate bond of the same maturity. This is because bonds issued by the U.S. government are considered virtually risk-free. The spread thus reflects the added compensation investors require for assuming the higher default risk of corporate bonds compared with risk-free government bonds.

The formula for calculating credit spread between bonds is as follows:

Credit Spread = Corporate Bond Yield - Treasury Bond Yield

Example

Let's say we want to calculate the credit spread for a 10-year corporate bond issued by ABC Corporation. The bond yields 5%, and the yield on a 10-year Treasury is 3%.

• Corporate bond yield (ABC Corporation, 10-year): 5%
• Treasury bond yield (10-year): 3%

Subtract the Treasury bond yield from the corporate bond yield.

• Credit Spread = Corporate Bond Yield - Treasury Bond Yield
• Credit Spread = 5% - 3% = 2%

In this example, the credit spread is 2% or 200 basis points. As such, investors require 2 additional percentage points in yield to hold ABC Corporation's bonds over the risk-free 10-year Treasury bonds. A higher credit spread means that the market perceives the corporate bond to have a higher risk of default. A lower credit spread suggests that the corporate bond is considered safer.

Credit Spreads in Options Trading

A credit spread can also refer to a type of options strategy where the trader buys and sells options of the same type and expiration but with different strike prices. In this context, bond yields are not involved.

In a credit spread involving options, 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 a 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.

Example

An example of a bear call spread would include buying a January 50 call on ABC for $2 and writing a January 45 call on ABC for $5.

Let's break this down:

1. You buy a January 50 call option on ABC stock for $2. This gives you the right to buy 100 shares of ABC at $50 per share until the expiration in January. Since each option contract controls 100 shares, you must pay $2 × 100 = $200.
2. Meanwhile, you sell (write) a January 45 call option on ABC for $5. This obligates you to sell 100 shares of ABC at $45 per share if the buyer exercises the option before expiration. You receive $5 × 100 = $500.
3. Your account receives a net credit of $3 per share ($5 received for writing the January 45 call minus $2 paid for buying the January 50 call). Since each options contract represents 100 shares, the net credit is $300 ($3 × 100 shares).

Your profit or loss depends on the price of ABC stock at expiration:

• If ABC is at or below $45 at expiration, both options expire worthless. You keep the $300 net credit as profit.
• If ABC is between $45 and $50 at expiration, the January 45 call is exercised, and you have to sell 100 shares at $45. The January 50 call expires worthless. Your profit will be the $300 net credit minus the difference between the stock price and $45, multiplied by 100 shares.
• If ABC is above $50 at expiration, both options are exercised. You have to sell 100 shares at $45 (January 45 call) and buy them back at $50 (January 50 call), resulting in a loss of $500. However, the $300 net credit offsets this loss, limiting the highest possible loss to $200.

This strategy is called a "credit spread" because the trader receives a net credit when entering the position.

The Bottom Line

A credit spread is relatively straightforward—it is the measure of the difference in yields between two debt securities that mature simultaneously but have different risks. Bonds with higher risks typically have higher yields. The term credit spread also refers to a strategy that involves purchasing one option while selling another similar option with a different strike price.

The yield spread between corporate bonds and 10-year Treasurys is vital for gauging economic health and investor sentiment. A good yield spread depends on perceptions about economic conditions, with narrow spreads indicating confidence and stability, while widening spreads suggesting increased concern about economic risks. By understanding how to interpret these spreads, investors can gain valuable insights into the economy and make more informed investment decisions.