Loading the player...

What is a 'Credit Spread'

A credit spread is the difference in yield between a U.S. Treasury bond and another debt security with the same maturity but of lesser quality. 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. Higher quality bonds, which have less chance of the issuer defaulting can offer lower interest rates. Lower quality bonds, with a higher chance of the issuer defaulting, need to offer higher rates attract investors to the riskier investment.

A credit spread can also refer to an options strategy where a high premium option is written and a low premium option is bought on the same underlying security. This provides a credit to the account of the person making the two trades.

Breaking Down the 'Credit Spread'

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. It can offer lower interest rates than higher risk issuers can. As the default risk of an issuer increases, the interest they offer increases, which will widen the credit between their bond and the U.S. Treasury bond.

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 fluctuate due to changes in expected inflation and changes in the supply of credit and demand for investment within particular markets. In an economic atmosphere of uncertainty, investors tend to favor safer U.S. Treasury markets, causing Treasury prices to rise and their yields to drop, thereby widening the credit spread between other lower quality bonds.

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, 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 and/or stable 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 where the trader receives a credit.

An example would be buying a January 50 call on ABC for $2, and writing a January 45 call on ABC for $5. The net credit received is $3. The trader gets to keep the $3 per share (with each contract representing 100 shares) if price of the underlying security if below $45 when the options expire. This is a bear call spread.

This can also be called a "credit spread option" or a "credit risk option".

RELATED TERMS
  1. Credit Spread Option

    A credit spread option is a financial derivative contract that ...
  2. Yield Spread

    A yield spread is the difference between yields on differing ...
  3. Nominal Yield Spread

    The nominal yield spread is the difference between a Treasury ...
  4. Spread

    The difference between the bid and the ask price of a security ...
  5. Spread Option

    A spread option is a derivative based on the value of the difference, ...
  6. Buy A Spread

    Buying a spread is an options strategy involving buying and selling ...
Related Articles
  1. Investing

    Find the Right Bond at the Right Time

    Learn about the types of bonds you should consider investing in, when you should be buying them and how to compare yields against their time to maturity.
  2. Investing

    How Bond Market Pricing Works

    Want to know how bond price are determined? Learn the basic rule of the bond market.
  3. Trading

    S&P 500 Options On Futures: Profiting From Time-Value Decay

    Writing bull put credit spreads are not only limited in risk, but can profit from a wider range of market directions.
  4. Investing

    Junk Bonds: A Correction May Be Looming

    Corporate debt issued by companies with riskier balance sheets and lower credit ratings typically carries higher interest rates.
  5. Investing

    Understanding Treasury Yield

    Treasury yield refers to the return on an investment in a U.S. government debt obligation, such as a bill, note or bond.
  6. Investing

    The Basics Of Municipal Bonds

    Investing in municipal bonds may offer a tax-free income stream, but such bonds are not without risks. Check out types of bonds and the risk factors of muni-bond.
RELATED FAQS
  1. In what types of financial situations would credit spread risk be applied instead ...

    Find out when credit risk is realized as spread risk and when it is realized as default risk, and learn why market participants ... Read Answer >>
  2. What's the difference between a credit spread and a debit spread?

    Learn about debit and credit option spread strategies, how these strategies are used, and the differences between debit spreads ... Read Answer >>
  3. Which factors most influence fixed-income securities?

    Learn about the main factors that impact the price of fixed-income securities, and understand the various types of risk associated ... Read Answer >>
Trading Center