To understand the concept of a spread, you must first know what is the Yield-to-maturity (YTM) of a fixed-income security. The YTM is the interest rate that equates the future cash flows of a security with its current market price. Given that the YTM is in effect a discounting rate, bond prices are inversely proportional to this rate.
It has been explained in detail in What is YTM?
What is a credit spread?
A spread in the fixed-income context refers to the excess yield that a security offers relative to another. The spread can be split into various components such as term spread, credit spread, and illiquidity spread.
Credit spread is the excess yield offered by a security relative to a risk-free security with the same maturity and almost similar liquidity. It can also be measured relative to another risky security. Credit spread reflects the creditworthiness of an issuer and compensates investors for the risk of potential default by the issuer of the security in paying its principal and/or interest obligations.
Credit risk and hence credit spreads are inversely related to the issuer rating. Lower the credit rating, higher is credit risk involved and higher is the credit spread. For example, say a 5-year ‘AAA’ rated corporate bond is trading at 7%, while another lower rated (riskier) corporate bond say 5-year ‘A’ rated is trading at 9.5%., the credit spread here would be 2.5% (9.5% - 7%).
Government securities have no default risk given that payments are guaranteed by the sovereign. Hence, the credit risk spread is zero for such securities.
What do credit spreads convey?
Credit spreads indicate the credit risk perceived by market participants/investors and are dynamic reflecting real-time market conditions, unlike credit ratings which are revised (upgraded or downgraded) with some lag. When the financial conditions of an issuer deteriorate, the probability of default increases leading to participants (lenders) demanding higher compensation in the form of extra yield. In effect, widening credit spreads are indicative of an increase in credit risk, while tightening (contracting) spreads are indicative of a decline in credit risk.
Credit spreads often widen during times of financial stress wherein the flight-to-safety occurs towards safe-haven assets such as U.S. treasuries and other sovereign instruments. This causes credit spreads to increase for corporate bonds as investors perceive corporate bonds to be riskier in such times.
How are credit spreads useful for market participants?
They help in determining the yield (interest rate) needed to price the future cash flows of a bond. A fair yield to adjust for the bond’s default risk can be obtained by adding the market observed credit spread (linked to credit rating of security) to the yield on a sovereign bond instrument similar in all other aspects (maturity, liquidity).
The credit spread can also feed into a building-block approach if other components are known. For example, if you know the expected inflation rate, real return, and other spreads (term, illiquidity) you can feed in the credit spread to determine the ‘fair yield’ that a bond should trade at.
Investors can compare the credit spread that the bond is trading at vis-à-vis the ‘fair credit spread’ based on his/her analysis of the issuer/security’s credit worthiness. If the market implied credit spread is higher (lower) than the fair credit spread, then the security is undervalued (overvalued) and the investor would look to buy (sell) that security and profit from a subsequent reversion to the fair value.
When investors anticipate a widening of spreads, they move to G-secs from corporate bonds to avoid capital loss due to rise in corporate bond yield or gain from capital appreciation following a decline in G-sec yields. On the other hand, when there is an anticipated tightening of spreads, investors move to corporate bonds to gain from any potential capital appreciation due to decline in corporate bond yields or to avoid capital loss due to rise in G-sec yield.
Just remember this about Credit Spread…
- It is calculated as the difference between the yield on a corporate bond and a benchmark rate (typically a G-sec yield of comparable maturity).
- It is typically quoted in basis points (100bps = 1%).
- It indicates the additional risk that lenders take when they buy corporate debt versus government debt of the same maturity.
- Changes in the spread indicate that perceptions around the risk of a specific issuer has changed or that general market conditions have changed. If the market becomes more skeptical about the creditworthiness of an issuing company, the spread of that company’s bonds widens (its yield relative to the benchmark widens). If sentiment improves, the relevant spread decreases.
