Credit spread
What is Credit spread?
A credit spread is the yield difference between a credit-risky bond and a reference security or curve with similar maturity and currency.
Why credit spreads matter
Credit spreads represent compensation for expected default loss, uncertainty, liquidity, risk aversion, and technical supply and demand. They also provide a market signal of changing perceived credit quality. Spread movement can materially affect corporate-bond prices even when government yields and contractual payments are unchanged.
How spreads are measured
Simple benchmark spread subtracts a comparable government yield. Interpolated spread uses a maturity-matched curve. Z-spread is the constant spread added to each spot rate to match price, while option-adjusted spread attempts to remove embedded-option value using a model. These measures answer different questions and should not be substituted silently.
Example
A five-year corporate bond yields 5.2% while a maturity-matched government reference yields 3.8%, producing a simple spread of 1.4 percentage points, or 140 basis points. If spread widens to 190 basis points while the government curve is unchanged, the corporate bond price generally falls.
How to interpret it
Compare spreads within compatible sectors, seniorities, currencies, maturities, and structures. A wider spread can indicate higher expected loss or simply lower liquidity and risk appetite. Convert spread into expected return only after considering default, recovery, downgrade, trading cost, and carry. For callable bonds, option-adjusted spread may be more informative than nominal spread.
Limitations
No reference security is truly risk-free, and curve construction affects the result. Spread measures can mix credit, liquidity, tax, option, and technical effects. Model-based spreads depend on volatility and exercise assumptions. During stress, observed prices may be stale or reflect forced selling, making a large spread both an opportunity and a warning.
Practical checklist
Name the spread measure and reference curve, align currency and maturity, and separate rate from spread duration. Review issuer fundamentals, rating migration, recovery, liquidity, seniority, and options. Attribute bond return between carry, roll, government-rate movement, spread movement, and defaults. Compare current spread with history only after accounting for changes in composition and quality. Document every curve and option-model assumption used, including the timestamp and underlying instruments, for reliable future reconciliation purposes.
Also known as: spread over benchmark