What is a Credit Spread?
Credit Spread is defined as the difference in yield of two bonds (mostly of similar maturity and different quality of credit). If a 5 year Treasury bond is trading at a yield of 5% and another 5 years Corporate Bond is trading at 6.5%, then the spread over the treasury will be 150 basis points (1.5%)
- An increasing credit spread can be a cause of concern since it may indicate a larger and quicker requirement of funds by the borrower (the Corporate Bond in the above example). One should assist the financial situation and the creditworthiness of the borrower before considering any investment. On the other hand, a narrowing credit spread indicates improving creditworthiness.
- Government Bonds offering a lower yield highlights a satisfactory financial position of the economy since there is no indication of dearth in funds by the country.
Credit Spread Formula
Following is the Credit Spread Formula-
Credit Spread = (1 – Recovery Rate) (Default Probability)
The formula simply states that credit spread on a bond is simply the product of the issuer’s probability of default times 1 minus possibility of recovery on the respective transaction.
Factors Affecting Credit Spread
Let’s assume a firm wants to borrow funds from the market over a 15 year period. However, the firm is not sure how the market will evaluate the risks of the company i.e., lack of clarity on what the spread will be. Borrowing costs can be severely impacted if the yield spread is high.
The management must consider the following factors before a decision on debt issuance:
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- Liquidity
- Taxes
- Accounting Transparency
- Defaulting history, if any
- Asset Liquidity
All the above-mentioned factors must be carefully studied as it can impact the widening of spreads. Any improvements in company analysis can result in a narrowing of spreads.
Interest Rates Changes with the Credit Spreads
Interest rates vary for various types of bonds and not necessarily in sync. For e.g., if there is a lot of uncertainty in the market, investors tend to park their funds in safe havens like US Treasuries causing the yield to fall since there is a surge of funds. On the other hand, the yields of Corporate bonds will increase due to an increased level of uncertainty. Thus, even though Treasury yields are falling in this instance, the spread is widening.
Analyzing changing credit spread for a category of bonds, one can get an idea of how cheap (widespread) or expensive (tight spread) the market for those bonds is pertaining to historical credit spreads.
Credit Spread’s Relation To Credit Risk
There is a common misconception that credit spreads are the single largest factor in determining the credit risk of bonds. However, there are multiple other factors that determine the ‘spread premium’ of bonds over other treasuries.
For e.g., bonds with favorable tax implications like Municipal bonds can trade at a yield lower than US treasuries. This is not due to the market considering them less risky, but due to the general perception of Municipal bonds considered almost as safe as treasuries and having a big tax advantage.
Similarly, many corporate bonds are illiquid, indicating possible difficulties in selling the bonds once purchased as there is not an active market for bonds. This will make investors expect a higher yield than otherwise, thereby increasing the credit spread.
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