FinancialQuotient

What is credit spread?

Franklin Templeton
Learning Academy

WHAT DOES IT MEAN?

Credit spread refers to the difference in the yield between two bonds of the same maturity but with differing credit quality.

It is a direct measure of the cost of risk, or the extra yield investors demand to take on a bond with a certain level of risk of defaulting, like corporate bonds, versus a risk-free benchmark security, such as United States Treasury bonds.

The width of the spread represents the difference in credit risk levels.

The lower the credit quality and rating of a bond, the higher the risk, resulting in a wider spread.

WHY IS IT IMPORTANT?

Credit spreads can be an important indicator of investor sentiment and the overall well-being of the economy.

When the spreads widen between different bonds of different risk ratings, investors can conclude that the market is factoring more risk of default on lower-grade bonds, implying that the economy is deteriorating.

Likewise, when the spread narrows, the market is considered to have expected a lower default risk brought about by a recovering economy.

Credit spreads are used by investors to strategise and make profitable trades. As a bond's yield is inverse to its price, the credit spread gives investors an idea of how cheap (wide spread) or expensive (narrow spread) the market is for a particular bond category or bond.

IF YOU WANT TO USE THE TERM, JUST SAY:

"Credit spread analysis can be used to compare any two fixed-income instruments to determine the investment opportunities by analysing the risk versus return."

A version of this article appeared in the print edition of The Sunday Times on August 27, 2017, with the headline 'What is credit spread?'. Print Edition | Subscribe