Credit Spread

Credit Spread is defined as the difference in yield of two bonds (mostly of similar maturity and different quality of credit).  It shows the risk premium that the investors would want to attain by holding the debt instruments which has different characteristics and credit risk.

Various factors, including the supply and demand, investor sentiments and market conditions, etc, influence it. A risky asset demand high spread. It is a benchmark to evaluate the attractiveness of different types of bonds. Analysts and investors closely monitor it to understand the market conditions and take informed investment decisions.

Credit spread management is a metric that can be used to measure the differences between the returns or the interest rates of two different kinds of debt instruments.

Typically, investors and analysts use this financial metric to calculate the yield differences risk-free government bonds and corporate bonds with the same maturity dates. Since are comparatively riskier than government bonds, they require higher yields. Thus, the credit spread strategy helps in measuring the extra return that corporate bondholders will expect to get as compensation for the higher risk level.

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. However, there are various methods to measure the credit spread in options which includes basis points or a percentage of risk-free rate. A close monitoring of this metric reveals the general market conditions, and investment opportunities available. It is also useful for bond pricing and risk management.

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.

Let’s assume a firm wants to borrow funds from the market over 15 years. However, the firm is not sure how the market will evaluate the company's risks, i.e., lack of clarity on what the credit spread for bonds 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:

• 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 vary for various types of bonds and not necessarily in sync.

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.

Let us understand the concept of credit spread management with the help of some examples.

Example #1

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.

Example #2

If a five-year Treasury bond is trading at a yield of 5% and another five years Corporate Bond is trading at 6.5%, then the spread over the treasury will be 150 basis points (1.5%).

The two simple examples given above clarify the concept.

There is a common misconception that credit spread for bonds is the single most significant factor in determining the credit risk of bonds. However, multiple other factors 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.

The above are ttwo different strategies that are frequently used in option trading. However, there are some differences between them, as follows.

• The credit spread in options is a strategy in which the trader gets a net premium on entering into the option position but in the latter the trader pays a net premium to enter into the option position.
• In case of the former, the option that is sold has a higher premium than the option that is bought whereas for the latter, the option bought has a higher premium than the option that is sold.
• For the former, the maximum profit is limited to the initial premium received and maximum loss is the difference between the strike price and premium. But the maximum loss for the latter is limited to the premium paid.
• The former helps in managing the risk because the profit is limited, whereas the latter can manage risk only if the trader is aware that the price will process in a particular direction.
• Credit spread strategy is used in any trading environment with higher volatility, but debit spread requires lower volatile environment.
• The concept of time decay work for the investors who go for credit spread but against the investors who go for debit spread.

Thus, the above are some essential differences between the two concepts.