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".