Definition: The credit spread, also called a yield spread, is the difference between two bonds’ yields that are the same in all respects except their credit rating. In other words, it’s the risk of alternative interest bearing securities (eg corporate bonds) compared to a benchmark.
What Does Credit Spread Mean?
What is the definition of credit spread? The credit spread is a measure to compare the creditworthiness of different borrowers in the capital markets. Considered over the same investment term the yield spread is a snapshot of all the risks taken when investing in bonds with higher interest rates compared to a benchmark.
Caveat emptor! Buyers of bonds are very much aware of crisis in financial markets where interest rates are spooked to dizzy levels. But in an era of negative rates investors are easily drawn to investments in bonds with higher rates – not knowing the risks. How can the investor make sense from the myriad of alternative bond issues from capital hungry companies? The answer is yield spreads. The yield spread is a summary of a much larger risk analysis of the borrower.
Let’s look at an example.
Example
In general, treasury yields are used as benchmark for all debt issued. If the 10-year Treasury note is trading at a yield of 4% and the comparable corporate bond at 6%, the latter trades at a yield spread of 200 basis points.
Let’s assume company A wants to borrow funds in the market over a ten-year period. But the company is unsure how the market will evaluate the risks of the company. In other words, they aren’t sure what the spread will be. Borrowing costs may be adversely affected if the yield spread is high.
Management should evaluate the following factors before deciding to issue debt: default, taxes, liquidity, accounting transparency, unfunded pension liabilities and asset liquidity. It is not only the possible default of the company that is in play. All the above factors must be carefully analyzed. This may impact the company negative resulting in a widening of credit spreads. An improvement in company analysis may result in narrowing credit spreads. The most important factor is possible default.
Summary Definition
Define Credit Spread: Credit spread means the difference between a treasury bond’s yield and a corporate bond’s yield.
