Credit Spread

A credit spread is the difference between the yield on a bond issued by a company or other risky borrower and the yield on a government bond of similar maturity. In the United States the benchmark is usually a Treasury security, so a corporate bond yielding 5.5 percent when the matching Treasury yields 4.0 percent has a spread of 1.5 percentage points, or 150 basis points. Investors, lenders and central banks watch spreads as a direct price of credit risk.

The spread is often confused with the bid-ask spread a dealer quotes, or with an FX spread; those are trading costs, not a reward for lending. It is also different from the gap between short and long government yields, which the yield curve describes. A credit spread compares two borrowers at the same maturity; the yield curve compares one borrower across maturities.

Imagine two friends ask to borrow money for a year. One has a steady job and has always paid you back; the other has missed payments before. You would lend to the first at a modest charge, but you would ask the second for more, because there is a real chance you will not get all your money back. The extra charge you ask of the riskier friend is the spread.

Bond markets work the same way, only at enormous scale. The government is treated as the friend who always repays, so its rate sets the floor. Every other borrower pays that floor plus a top-up that reflects how risky lenders think it is. When people grow nervous about the economy, they demand bigger top-ups from everyone except the government, and spreads widen.

The basic calculation subtracts the benchmark yield from the bond's yield, both measured at the same maturity:

• $y_{\text{bond}}$ is the yield to maturity of the corporate or other risky bond.
• $y_{\text{benchmark}}$ is the yield of a government bond, such as one of the Treasury notes, with a matching maturity.
• The result is usually quoted in basis points, where 100 basis points equal one percentage point.

Suppose a five-year corporate bond yields 6.20 percent and the five-year Treasury yields 4.05 percent. The spread is $6.20\% - 4.05\% = 2.15\%$, or 215 basis points. On a $1,000,000 holding, that spread is worth about $21,500 a year in extra income over the Treasury, the price the investor charges for bearing the issuer's risk.

Rating agencies divide bonds into two broad groups, and spreads differ sharply between them:

• Investment grade. Bonds rated BBB- (Baa3 at Moody's) or higher. Their spreads are usually measured in tens to low hundreds of basis points because default is rare.
• High yield. Bonds rated below that line, also called junk bonds. Their spreads are several times wider and swing far more with the economic cycle.
• Credit derivatives. A credit default swap premium expresses the same risk as a running insurance cost, and it usually moves closely with the cash bond spread.

Spreads blew out in the 2008 crisis, when the ICE BofA US high-yield index spread rose above 20 percentage points in December 2008, and again briefly in March 2020 before central bank support pulled them back.

Many bonds carry options: the issuer may call the bond early, or a mortgage borrower may prepay. A simple yield comparison mixes the value of that option into the spread. The option-adjusted spread (OAS) strips it out by modelling many possible paths for interest rates and finding the constant spread over the benchmark curve that makes the bond's modelled value equal its market price. OAS is the standard measure in published bond indices and in comparisons between callable bonds, mortgage-backed securities and plain bullets. Other variants include the zero-volatility spread and the spread over a swap curve rather than Treasuries, now usually priced off SOFR.

• Expected default losses. The probability that the issuer defaults, times the share of the investment lost if it does.
• Liquidity. Corporate bonds trade less often than Treasuries, so investors ask a premium for the difficulty of selling quickly; see liquidity.
• Risk appetite. In calm markets investors accept thin spreads; in a recession or a panic they flee to Treasuries and spreads widen even for sound issuers.
• Policy. Asset purchases such as quantitative easing and the Federal Reserve's 2020 corporate credit facilities narrowed spreads by adding a large buyer.

Because widening spreads raise borrowing costs for firms, economists treat them as an early warning of tighter credit. The spread measures risk relative to a risk-free rate, so it can also widen when government yields fall faster than corporate yields in a flight to safety. Spreads also feed the pricing of securitization deals and of loans in private credit.

• Federal Reserve Bank of St. Louis: ICE BofA US High Yield Index Option-Adjusted Spread
• U.S. Department of the Treasury: Interest Rate Statistics