What is a 'Credit Spread'
A credit spread is the difference in yield between a U.S. Treasury bond and a debt security with the same maturity but of lesser quality. A credit spread can also refer to an options strategy where a high premium option is sold and a low premium option is bought on the same underlying security. Credit spreads between U.S. Treasuries and other bond issuances are measured in basis points, with a 1% difference in yield equal to a spread of 100 basis points.
BREAKING DOWN 'Credit Spread'
To illustrate, if a 10-year Treasury note has a yield of 2.54% while a 10-year corporate bond has a yield of 4.60%, then the corporate bond offers a spread of 206 basis points over the Treasury note.
Credit spreads vary from one security to another based on the credit rating of the issuer of the bond. Debt issued by the United States Treasury is used as the benchmark in the financial industry due to its risk-free status, being backed by the full faith and credit of the U.S. government. As the default risk of the issuer increases, its spread widens.
Credit spreads also fluctuate due to changes in expected inflation and changes in the supply of credit and demand for investment within particular markets. For instance, in an economic atmosphere of uncertainty, investors tend to favor safer U.S. Treasury markets, causing Treasury prices to rise and current yields to drop, thereby widening the credit spreads of other issuances of debt.
There are a number of bond market indexes that investors and financial experts use to track the yields and credit spreads of different types of debt with maturities ranging from three months to 30 years. Some of the most important indexes include High Yield and Investment Grade U.S. Corporate Debt, mortgage-backed securities issued by Fannie Mae, Freddie Mac or Ginnie Mae, tax-exempt municipal bonds, and government bonds. Credit spreads are larger for debt issued by emerging markets and lower-rated corporations than by government agencies and wealthier nations. Spreads are larger for bonds with longer maturities.
Credit Spreads as an Options Strategy
A credit spread can also refer to a type of options strategy.
An example would be buying a Jan 50 call on ABC for $2, and writing a Jan 45 call on ABC for $5. The net amount received (credit) is $3. The investor will profit if the spread narrows.
This can also be called a "credit spread option" or a "credit risk option".