Credit Spread Explained: What Investors Are Compensated For

Imagine you are lending money to someone. Let’s say your friend asks to borrow $100 and promises to pay you back in a week. You probably wouldn’t charge your friend any extra, you’d just expect your $100 back. Now, imagine a stranger asks to borrow $100 for a week. You might feel a bit hesitant. You don’t know this person as well, so there’s a slightly higher chance they might not pay you back. To compensate for this increased uncertainty, you might ask for a little extra in return, perhaps $105 at the end of the week instead of just $100. That extra $5, in a simplified way, is similar to what we call a credit spread in the world of bonds.

In the financial world, companies and governments often need to borrow large sums of money. They do this by issuing bonds. Think of a bond as an IOU, a formal promise to pay back borrowed money over a set period, with regular interest payments along the way. When a company, let’s say a well-known tech company, issues a bond, they are essentially borrowing money from investors like you and me, or large institutions.

Now, governments are generally considered very safe borrowers, especially governments of stable, developed nations. Bonds issued by these governments, like US Treasury bonds, are often seen as the benchmark for risk-free investments. Their likelihood of default, meaning failing to pay back the bond, is considered extremely low.

Corporate bonds, on the other hand, are bonds issued by companies. These companies, unlike governments, can face various challenges. Their businesses might not perform as expected, they could face increased competition, or the overall economy could take a downturn. All of these factors increase the risk that the company might struggle to repay its debts, including its bonds. This risk is what we call credit risk, or default risk, which is the chance that the company will fail to make interest payments or repay the principal amount of the bond when it’s due.

The credit spread, also sometimes called the default spread, comes into play when we compare corporate bonds to those safer government bonds. It’s the extra yield, or extra return, that investors demand when they buy a corporate bond compared to a similar government bond. Think back to our friend and stranger analogy. The stranger, representing the riskier corporate borrower, needs to offer you a little extra to convince you to lend them money. This extra ‘something’ is the credit spread.

Specifically, the credit spread is usually measured as the difference in yield between a corporate bond and a government bond of the same maturity, meaning they both mature or come due at roughly the same time. This difference is expressed in basis points, where 100 basis points equals 1 percentage point.

So, what exactly does this credit spread compensate investors for? Primarily, it compensates them for taking on that additional credit risk – the risk that the company issuing the bond might default. The wider the credit spread, the riskier the company is perceived to be by the market. A company with a strong financial track record and a stable business will typically have a narrower credit spread, meaning investors don’t demand as much extra return because the perceived risk of default is lower. Conversely, a company facing financial difficulties or operating in a volatile industry will likely have a wider credit spread, as investors demand more compensation for the higher perceived default risk.

Beyond default risk, the credit spread can also compensate for other factors. Liquidity risk is another consideration. Corporate bonds are generally less liquid than government bonds, meaning they might be harder to sell quickly at a fair price. This lack of liquidity is another form of risk that investors might be compensated for through a wider credit spread. Think about selling your house versus selling a government bond. Selling a house might take time and effort, while selling a government bond is usually much quicker and easier. Corporate bonds can fall somewhere in between, and less liquid corporate bonds may offer a bit more yield.

In essence, the credit spread is a vital signal in the bond market. It’s the market’s way of pricing in the various risks associated with lending to a particular company. It tells investors how much extra return they should expect for taking on the credit risk and other related risks compared to investing in a near risk-free government bond. Understanding credit spreads is therefore crucial for anyone involved in the bond market, from individual investors to large fund managers, as it helps them assess the relative value and risk of different investment opportunities.