Definition
Credit spread refers to the yield differences between two bonds of the same maturity and different credit quality. One of the bonds is typically set as a benchmark. For instance, one bond can be a US Treasury bond (benchmark), and the other can be a corporate bond; there is an expected yield difference between the bonds due to the credibility of the issuing authority. This difference in credibility gives rise to the credit spread in the bonds.
Explanation of the concept
The credibility of the Government-backed bonds is greater than any other corporate bond. That’s because there are rare chances of default on Government bonds. Hence, the return is low. On the other hand, the chances of default in the case of corporate bonds are comparatively higher. So, a higher return can be expected.
Credit spread helps to understand if it’s logical to presume additional risk on the additional return provided by corporate bonds. Suppose there is a minor difference in the return between corporate bonds and US Treasury bonds, but corporate bonds contain excessive risk. So, an investment in corporate bonds may not be logical.
So, the length of a difference between the US Treasury bond (it’s a benchmark and can be different) and corporate bond is termed credit spread and measured in the unit called basis points. It’s an effective unit to compare risk-free and corporate bonds by using the concept of risk.
Basis point
A difference of 1% in the yield is assigned 100 basis points. So, if the yield difference between two bonds is 0.5%, it’s said to be a difference of the 50 basis points. Similarly, if the yield offered by your commercial bank is 1% more than LIBOR – London Inter-Bank offered Rate, it’s said that the bank is paying more interest by 100 basis points.
The following formula is used to calculate the credit spread.
Credit spread = corporate bonds yield – Treasury bond yield.
It’s logical to expect a positive answer from the formula as corporate bonds are expected to have higher risk/return than corporate bonds.
Example of calculating credit risk
Suppose US treasury bonds with a maturity of 5 years has a 4% yield. And the bonds of ABC limited have a 5.5% yield. Given details can be put in the formula to calculate the credit spread.
Credit spread = corporate bonds yield – Treasury bond yield.
Credit spread = 5.5% – 4%
Credit spread = 1.5% or 150 basis point
Interpretation
The credit spread of ABC limited is 1.5% or 150 basis points. The credit spread can be compared with other securities to assess if return/yield is in line with the risk presumed.
Risk/rewards comparative assessment
The return generated by the corporate bonds is expected to be higher than the return generated by the treasury bonds; that’s because of a higher risk carried by the corporate bonds than treasury bonds backed by the Government/state.
Credit spread can be different for the bonds of different companies. The bonds with higher quality have low chances of default and a low Rate of return. On the other hand, low-quality bonds are perceived to be riskier investments, and investors expect a higher rate of return from issuing companies. It’s also important to note that spread is affected by the credibility of the issuing company and changes in the external economic conditions like changes in inflation, the overall need of investment or availability of savings in the economy, and other liquidity factors of the business.
Further, if there is uncertainty in the economic environment, the people tend to invest in the US treasury bonds and avoid risk. This results in a higher price of the treasury bonds and lower return. On the other hand, if economic conditions are stable, investors tend to invest more in corporate bonds to generate a higher return.
So, if the price of the treasury bonds is higher, it means there is more demand for risk-free investment and higher instability in the economic environment. Hence, it can be used as a barometer to measure pressure on the economy.
What’s conveyed by credit spread?
Credit spread is a prime indicator of the credit risk investors perceive in the security. The market’s response and perception directly impact the yield. For instance, if the financial conditions of the lenders deteriorate, the lenders demand a higher return on presuming higher risk, future probability of default increases. Hence, the length of a credit spread indicates an investor’s perception of risk.
Factors impacting on the credit spread
Default risk is considered to be the main factor in determining credit spread. However, multiple internal and external factors impact the bond yield and credit spread. These factors include the business’s financial condition, external economic environment, savings in the economic system, and any other factors impacting the investor’s perception of the business.
Example of factors in impacting credit spread
US Treasury bond is considered the benchmark for the bonds issued by the business. So, if the current yield of the 5-year Treasury bond is 5% and corporate bond is 6%. The spread, in this case, is 100 basis points. Suppose in such a situation the company wants to raise capital by issuing bonds, and the company’s management may not be clear about how the market is expected to assess their risk and the yield on the bonds. If the spread is higher, it will adversely impact the finance cost and overall business profitability. On the other hand, if the spread is lower, It may not attract the investors and lead to project failure.
So, the business management needs to consider multiple factors and determine the spread. These factors include but are not limited to the business risk of default, current gearing status, current liquidity position, accounting transparency, taxes, and other market factors affecting the yield. Further, it’s important to note that issuing company must provide a return greater than risk-free securities to compensate investors for the additional risk.
Uses of credit spread
The following two are the main uses of the credit spread.
1. Valuation of bond
The bonds issued by the company are recorded as a liability in the financial statement. However, this liability needs to be valued by estimating future cash flow in terms of the estimated cost of capital. Since yield on the bonds (cost of capital) can be calculated using credit spread. Hence, it’s useful in the process of valuing liability.
2. Investment appraisal
Investors use credit spread to assess if their investment in bonds is financially feasible. In other words, if the return offered by corporate bonds is in line with the risk presumed by investment. For instance, if credit spread is higher than market security of similar risk, the potential investment opportunity is financially feasible. On the other hand, if the credit spread is lower than comparative market security, the potential investment is not financially feasible.
Impact of the pandemic on credit spread
The pandemic of COVID-19 severely impacted businesses around the world. That was due to favorable aspects of the monetary policy. However, credit spread tightened throughout a pandemic.
Significant Government funding was observed that led to enhanced liquidity and higher demand for the bonds. This led to a lower shift of yield and lower credit spread. So, the bond issuers have successfully locked future funds requirements at reduced cost and lower credit risk.
Conclusion
Credit spread helps to understand if the return offered on the corporate bonds is in line with the additional risk presumed. It helps potential lenders to assess the feasibility of investment in terms of risk and return. This concept compares reliable US treasury bonds with corporate bonds; the difference is a credit spread. Further, it’s a measure in terms of a basis point, and 1% of the difference equals 100 basis points.
The credit spread mainly changes due to change in the default risk of issuing company. However, other internal businesses and external environmental factors impact the length of the spread point. For instance, if economic conditions worsen, investors tend to invest more in risk-free treasury bonds, and demand for corporate bonds decreases. So, to attract investors, the companies increase yield leading to a higher spread.
Frequently asked questions
What are performance factors important for the equity and credit market?
It’s important to note that the equity market is more focused on the profit-generating ability of the business. If the business gets profit, it will be able to pay dividends and experience capital appreciation.
On the other hand, the credit market is mainly about the ability of the business to make timely payments of interest and repay the principal amount on a timely basis. So, it’s more about the cash-generating ability of the business.
What’s the difference between credit rating and credit spread?
Credit rating helps to assess the ability of the bonds issuing company to meet their obligation. The assessment is based on debt size, macroeconomic environment, and the ability of the business to generate cash flows. On the other hand, credit spread is about assessing return due to the presumption of additional risk by investing in the corporate bonds of the corporate sector and not investing in the Government-backed bonds.
What’s the difference between tightening and widening of credit spread?
These terms reflect the movement of yield and changes in the credit risk. If credit risk increases, the yield on bonds increases, which leads to an increase in credit spread. Such a situation is called widening of the credit risk. On the other hand, if credit risk decreases, the yield on bonds decreases, which leads to a decrease in credit spread. Such a situation is called tightening of the credit spread.
