Credit Spread Explained
If you have ever looked at bond prices or yields, you may have come across the term credit spread.
But what does it actually mean?
A credit spread is basically the difference between the yield of a corporate bond and the yield of a similar government bond.
For example, imagine:
Government bond: 4%
Company bond: 6%
The difference is 2%.
That 2% is the credit spread.
Why does the company need to offer a higher return?
Because lending money to a company usually involves more risk than lending to a highly creditworthy government. Investors therefore expect some additional return for taking that risk.
What happens when the spread gets wider?
Let’s say a company’s bond initially has a yield of 5%, while the comparable government bond yields 4%.
The credit spread is 1%.
Later, investors become less confident about the company. They may now want a higher return to hold its bond.
The company bond yield rises to 6%.
The government bond is still at 4%.
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The spread is now 2%.
This is called spread widening.
The opposite is spread tightening. If investors become more confident and require less additional return, the spread can become smaller.
Why do credit spreads move?
There isn’t just one reason.
Credit spreads can change because of:
- A company’s financial performance
- Changes in credit ratings
- Economic conditions
- Interest rates
- Investor demand
- Market confidence
- Liquidity
During periods of market stress, investors often become more cautious about credit risk. This can lead to wider spreads.
Credit spreads are therefore closely watched in credit and fixed-income markets. They give investors an idea of how much additional return the market is demanding for taking credit risk.
For example, if you hear that “corporate credit spreads are widening,” it generally means investors are asking for more compensation to hold corporate debt.
