Credit Spread: Meaning, Types, Uses and Importance

Key takeaways: 

• Credit spread is a tool which is used to assess the creditworthiness of the issuers. 
   
• It is a gap in interest rates between two financial instruments. In this, mostly one has the higher risk and the other has lower risk. 
   
• Many factors affect the credit spreads like credit quality of the issuer, economic conditions, market changes etc. 

Bonus tip: 

Do you know? The outstanding gross notional in the global Credit spread swaps has dropped from about US$60 trillion to under US$10 trillion. This happened because of the use of trade compression. 

When even a small hint of risk is sensed by the investors, the gap between two bonds increases quietly, this is called credit spread. 

Imagine that two of your friends are asking for ₹10,00,000 for 1 year. One of them is having a stable job and income. The other has a freelancing job with irregular income. In this situation: 

• You let your friend A borrow at 5% interest. 
• On the other hand, you let your friend B borrow at 8% interest rate because of higher risk. 

This gap of 3% between the two is like a credit spread. 

Example, there are two different bonds: 

1. A government bond issued by the government of India at 7%. 
2. A corporate bond issued by Tata Motors at 9%. 

Credit spread = 3%

This clearly means that an investor will demand 2% extra return to invest in the corporate bond. 

What is a credit spread? 

Credit spreads are also called yield spreads. It is a gap between interest rates or yields of two bonds with the same maturity. One of them is with higher risk and the other has comparatively lower risk. As per the golden rule of credit spread, the wider the spread, the greater the perceived risk. 

The context in which credit spread is used are bonds or other fixed income securities. Credit spreads are used by the investors to know the creditworthiness of the issuer. Credit spread is also explained as pricing benchmarks for products like corporate bonds, mortgage backed securities and credit default swaps. 

For example 1, there are two different bonds: 

1. A government bond issued by the government of India at 6%. 
2. A corporate bond issued by “XYZ” company at 8%. 

Credit spread will be 200 basis points (2%). It is the gap between the above two interest rates. 

Example 2, there are two different bonds with interest rates 4% and 6% interest rates of government bond and corporate bond respectively. The credit spread will be 2% which means 200 basis points. 

Credit Spread Calculator 

You can use any online credit spread calculator to instantly estimate the credit spread of a corporate bond before making any decision related to the investment. 

While using the credit spread calculator, you just have to enter two basic details: 

• The corporate bond yield
• The government bond yield

After pressing “=”, you will get your results. 

For example, corporate bond yield is 5% and the government bond yield is 1.8%. The maturity year is 10 years for both the bonds. To get instant results of the credit spread, use the credit spread calculator which shows the result of 320 basis points.

Credit Spread Option Strategy 

The credit spread option strategy means buying and selling of options that have the same underlying security and expiration but different strike. This is used in a way that there is net inflow of option premium which leads to naming such strategies as “credit spreads”. 

Factors influencing the credit spread: 

There are many factors that influence the credit spread and some of them are as follows: 

These are some of the factors that influence the credit spread. 

Conclusion: 

Overall, credit spreads are valuable information for the investors.  It is a gap between interest rates or yields of two bonds with the same maturity. One of them is with higher risk and the other has comparatively lower risk. Factors like GDP, inflation, unemployment rates, different sectors of the economy, credit quality of the issuer influences the credit spread. 

FAQs: 

What is a credit spread option strategy? 

The credit spread option strategy means buying and selling of options that have the same underlying security and expiration but different strike.

What is a credit spread? 

It is a gap between interest rates or yields of two bonds with the same maturity. One of them is with higher risk and the other has comparatively lower risk.

How are credit spreads calculated for credit default swaps? 

The credit spreads on the credit default swaps are calculated on the basis of the expected loss of the underlying instrument.

Is “put credit spread” a commonly used strategy among large investors? 

Yes, the put credit spread is commonly used by investors to generate income and also managing the risks in option trading. 

How often do you use credit spreads? 

Credit spreads are used by the investors to know the creditworthiness of the issuer regularly and to generate income while managing the downside risks.