Learn how credit spreads measure extra yield over a benchmark, why they widen or tighten, and how they differ from overall bond yields and default probabilities.
Two bonds with similar repayment dates can offer different yields because their borrowers and trading characteristics differ. A credit spread helps isolate the extra yield attached to one bond relative to a benchmark.
This guide continues our explanations of bond yield, duration, and the yield curve. It explains how spreads are calculated, why they move, and how they can change even when a company’s overall borrowing yield falls.
What Is a Credit Spread?
In bond markets, a credit spread is a yield difference between a bond carrying credit risk and an appropriate reference security or curve. Corporate bonds are commonly compared with government securities in the same currency and with comparable maturities.
The St. Louis Fed describes spreads as a way to examine corporate borrowing conditions. The measure helps separate changes in benchmark interest rates from changes in the compensation demanded for holding corporate debt.
The term also appears in options trading, where it describes a different type of strategy. Here, it refers to the yield premium in credit markets.
How to Calculate a Simple Spread
Suppose a hypothetical corporate bond yields 5.6% and a comparable Treasury yields 4.1%. Subtracting the benchmark gives a spread of 1.5 percentage points, or 150 basis points.
One basis point equals 0.01 percentage points, and 100 basis points equal one percentage point. The 150-basis-point figure is the gap between yields, not a 150% return or an extra cash payment promised by the issuer.
For the subtraction to be useful, compare compatible currencies, maturities, and yield conventions. A short corporate bond and a long Treasury can differ because of the yield curve even before credit risk is considered.
What Investors Are Being Paid For
A borrower may miss interest or principal payments. Investors therefore consider the likelihood of default and how much might be recovered if default occurs. Financial leverage, earnings, cash reserves, and contractual seniority can affect that assessment.
Spreads also reflect the compensation investors demand for uncertainty and for holding securities that can be harder to sell. Taxes, market structure, and the particular benchmark can contribute to the measured difference.
Research from the San Francisco Fed examines why expected default losses alone do not explain corporate spreads. Consequently, a spread of 2% does not imply a 2% probability of default.
Widening and Tightening
A spread widens when the extra yield relative to the benchmark increases. It tightens when that gap decreases. Widening can accompany concern about repayment, reduced market liquidity, or a stronger preference for safer assets.
Tightening can reflect improving finances, stronger demand for corporate debt, or greater willingness to accept risk. It does not prove that a bond is inexpensive: the compensation available for taking that risk may also have become smaller.
The same spread can have different significance across industries, ratings, and market conditions. A useful reading specifies which securities are being measured and which period provides the comparison.
A Lower Yield Can Accompany a Wider Spread
Start with the earlier hypothetical pair: a corporate yield of 5.6% and a Treasury yield of 4.1%, giving a 150-basis-point spread.
Now suppose the Treasury yield falls to 3.5% while the corporate yield falls to 5.3%. The corporate bond’s yield has declined by 30 basis points, but its spread has widened to 180 basis points because the benchmark fell by 60.
The issuer could face a lower absolute borrowing yield while investors demand more compensation relative to Treasuries. Looking only at the corporate yield would miss that change in relative conditions.
These figures are illustrative, not current quotes. Actual financing costs also depend on issuance terms, fees, hedging, and whether a company is refinancing an older obligation.
Why Spreads Affect Bond Prices
For an existing conventional fixed-rate bond, a higher required yield generally means a lower price. Its yield can rise because benchmark rates increase, because the credit spread widens, or because both occur.
When benchmark yields fall while spreads widen, the effects can offset. The final price movement depends on the size of each change and the security’s sensitivity.
Our duration guide explains sensitivity to yield changes. Credit investors also examine spread duration, which estimates price sensitivity to a spread change while holding the benchmark curve constant. Both are approximations rather than guarantees about returns.
Simple Spreads and Option-Adjusted Spreads
A simple maturity-matched spread is a starting point. A callable bond adds another complication: the issuer’s right to repay early changes the value and expected timing of payments.
An option-adjusted spread, or OAS, uses a model to account for embedded options when expressing the spread over a reference curve. This can improve comparisons among securities with different call features, but the result depends on modeling assumptions.
FRED’s series notes describe an investment-grade corporate OAS index calculated relative to a spot Treasury curve. Such an index summarizes a defined portfolio; it is not a quote for every corporate bond.
Reading Market-Wide Spread Indices
An investment-grade index and a high-yield index cover different credit universes. Their typical spreads differ, so compare each series with its own history and construction before drawing conclusions.
Check ratings, maturity range, sector mix, currency, and weighting. Changes in index membership can also influence the aggregate. A market-wide average may stay calm while a particular issuer or industry faces serious difficulty.
Spreads can provide evidence of changing financial conditions, but they do not supply a reliable countdown to recession or a precise forecast for stock prices.
Using Spreads Without Chasing Yield
A larger spread can be compensation for meaningful additional risk. It may reflect a genuine improvement in prospective value, deteriorating fundamentals, or both. The percentage alone cannot distinguish those explanations.
FINRA’s due-diligence guide recommends examining creditworthiness and contractual terms alongside yield. Review repayment capacity, seniority, call provisions, diversification, and the possibility of needing to sell.
Separate three questions: what the bond yields, how much of that yield exceeds the benchmark, and what risks explain the difference. That approach makes a spread useful as an analytical measure without treating it as a promised excess return.
Frequently Asked Questions
What Is a Credit Spread in Simple Terms?
In bond markets, a credit spread is the difference between a bond’s yield and an appropriate benchmark yield. Corporate bonds are often compared with government bonds of similar maturity in the same currency.
How Many Basis Points Are in One Percentage Point?
There are 100 basis points in one percentage point. A corporate yield of 5.6% minus a Treasury yield of 4.1% produces a spread of 1.5 percentage points, or 150 basis points.
Can a Spread Widen While the Bond Yield Falls?
Yes. If the benchmark yield falls faster than the corporate yield, the gap widens even though the corporate bond’s absolute yield declines.
Does a Credit Spread Measure Default Probability?
Not directly. Spreads can reflect expected default losses, risk premiums, liquidity, taxes, and other influences. A 2% spread does not by itself imply a 2% probability of default.
What Is an Option-Adjusted Spread?
An option-adjusted spread uses a model to account for embedded options when expressing a bond’s spread over a reference curve. It helps comparisons but remains dependent on modeling assumptions.
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