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What Is Bond Credit Spread?
Bond credit spread (as opposed to options credit spread) indicates the different yields of two bonds with the same maturity but different credit ratings. Put another way, bond credit spread measures the difference in returns between two bonds due to disparate risk levels.
You might be thinking, “I don’t invest in bonds. Why should I care about bond credit spread?” One reason is that bond credit spreads can be a leading indicator of the overall economic environment. Bond credit spread also is a high-level risk analysis of the borrower (the bond issuer), so investors can use bond credit spread as one marker of an issuer’s or an industry’s creditworthiness.
Key Takeaways
- Bond credit spread is a snapshot of the different yields between a Treasury bond (T-bond) and a corporate bond or municipal bond of the same (or similar) maturity.
- In general, the higher the spread, the riskier the corporate or municipal bond.
- All other factors being equal, shorter-dated bonds have narrower credit spreads because default risk increases with longer terms.
- Bond credit spreads move continuously, just like stock prices.
- A narrowing bond credit spread can point to improving economic conditions and lower overall risk.
- A widening bond credit spread typically suggests worsening economic conditions and higher overall risk.
How to Calculate Bond Credit Spread
Use the following equation to calculate a bond credit spread:
Credit spread = corporate bond yield – Treasury bond yield
Some investors substitute a benchmark bond yield of their choice in place of the Treasury bond yield. In that case, you would use the following equation instead:
Credit spread = corporate bond yield – benchmark bond yield
Is Options Credit Spread the Same Thing as Bond Credit Spread?
Credit spread can refer either to an options investing strategy or to bonds, and these are two very different things. The following terms are all related to options strategies:
- Debit spread
- Credit put spread
- Credit call spread
- Iron butterfly (“In-a-Gadda-Da-Vida,” anyone?)
- Iron condor
- Short butterfly
- Short condor
This article focuses solely on bond credit spread, which is sometimes called the yield spread.
Bond Credit Spread Example
Let’s consider bond credit spread as exemplified by two hypothetical bonds from different issuers. First, we have a 10-year Treasury note (T-note) issued by the U.S. federal government. The second bond is a 10-year Alphabet (corporate) bond. All discussions of bond credit spread assume the yield-to-maturity (YTM), which is often referred to simply as the yield.
The hypothetical yield, or interest rate, of the 10-year T-note is 1.54%, and the hypothetical yield of the 10-year Alphabet bond is 3.60%. In this example the Alphabet bond offers a 2.06% spread over the T-note:
3.60% – 1.54% = 2.06%
The credit spread can also be referred to as a 206-basis-point risk premium.
A government bond such as the T-note is frequently used as the benchmark rate because U.S. Treasury bonds are considered the closest thing to a risk-free investment, with a nearly nonexistent probability of default. The bond credit spread quantifies the additional risk lenders take on when they buy corporate debt (bonds) versus government debt (bonds) of the same or similar maturity.
What Is a Normal Bond Credit Spread?
Historically, 2% is the average credit spread between 2-year BBB-rated corporate bonds (see below for more about bond credit ratings) and 2-year U.S. Treasuries. However, economic conditions now change so quickly that an average credit spread may be a thing of the past. Dig into various statistics and graphs related to the bond credit spread (both current and historical) at the FRED online database from the Federal Reserve Bank of St. Louis.
What Does Bond Credit Spread Indicate About Market Conditions?
Bond credit spread can be a bellwether of overall economic conditions. Changes in bond credit spread can suggest the following:
- Changing perceptions of default risk by a specific bond issuer
- Changing perceptions of general market conditions
- Both of the above
Let’s say the market becomes more skeptical about the creditworthiness of fictional issuing company Wheels-R-We (a traditional automaker that produces gas-powered cars). Consequently, the spread increases, or widens, for Wheels-R-We bonds. This means the yield (the interest rate) gets pushed higher for Wheels-R-We bonds relative to the benchmark yield. If markets overall become more negative and risk-averse, bond credit spreads in general tend to widen.
But if sentiment improves toward either Wheels-R-We or the overall auto industry, the relevant credit spreads would fall, or narrow. In this case, the yield declines for Wheels-R-We bonds. Narrowing credit spreads can indicate improving private (corporate or municipal) creditworthiness along with overall economic growth.
Why Do Bonds Have Credit Ratings?
Anytime you loan money, you’re accepting the risk that the borrower will default, or fail to pay back the loan in full. Each specific bond’s credit rating partially quantifies that risk of default.
If you purchase a bond, you’re loaning money to the bond issuer. With a Treasury bond (T-bond), you’re loaning money to Uncle Sam; with a Miami municipal bond, you’re loaning to the City of Miami; with a Ford corporate bond, you’re loaning to Ford Motor Company. Each bond issuer (a borrower) receives a credit rating from either Moody’s or Standard & Poor’s (S&P). For Moody’s credit rating table, refer to this PDF; S&P explains its rating process here.
The highest credit rating is Aaa/AAA (Moody’s/S&P), and the lowest credit rating is Caa3/D. Credit ratings are also split into two groups: investment grade and non-investment grade (or “high yield”). Finally, each separate bond issue is individually rated. Individual rating means bonds issued by the same organization but at different times or with different maturities can have different credit ratings.
Bond investors use the credit spread to weigh the risk of default against the potential reward of a bond’s yield. Other factors that affect the risk of default include the broad economic environment and the stability or instability of the bond issuer’s industry—for example, the traditional auto industry during the period of increasing “green” regulations regarding electric cars.
Can Credit Spread Be Negative?
A negative bond credit spread can be a harbinger of specific economic changes. During the early 21st century, academics and practitioners introduced several statistical pricing models for bond credit spread. Business analytics firm Dun & Bradstreet published one extensive analysis of such models that includes information about negative bond credit spread.
