Credit Spread

In fixed-income markets, credit spreads serve as a key indicator of perceived credit risk. They represent the additional yield investors demand over a risk-free benchmark, such as a government bond, to compensate for the possibility of default or lower liquidity. By comparing bonds with similar maturities, credit spreads highlight the compensation investors expect for bearing default and liquidity risks. Tracking these spreads over time can also reveal shifts in market sentiment, periods of stress or recovery, and opportunities across issuers and sectors.

Table of contents

• What is a credit spread?
• Why do investors calculate credit spreads?
• What factors influence credit spread?
• Movements in credit spreads
• How do credit spreads impact bonds?
• How to calculate credit spread?
• Credit spread formula
• Example of credit spread

What is a credit spread?

A credit spread is the yield difference between a non-government bond and a government security of the same or similar maturity. For example, if a five-year AAA-rated corporate bond yields 7.10% and the five-year government security yields 6.20%, the credit spread is 0.90 percentage points or 90 basis points. This spread compensates investors for assuming risks such as default, downgrade, liquidity, and market uncertainty. In India, credit spreads are usually calculated against government securities (G-Secs) of comparable maturity.

Read Also: What are credit risk mutual funds?

Why do investors calculate credit spreads?

Credit spreads are calculated to understand two important aspects:

• Whether the yield compensates adequately for the credit risk being taken over the risk-free rate.
• How different bonds compare when adjusting for credit quality and liquidity.

Spreads may help investors analyse opportunities, understand entry and exit conditions, and monitor portfolio risk. They also assist in evaluating new issues, setting portfolio benchmarks, and attributing performance between rate-related and credit-related effects.

What factors influence credit spread?

Spreads may move due to both issuer-specific and broader market factors, such as:

• Credit quality and leverage: Higher debt or weaker cash flows tend to widen spreads.
• Business model and sector risk: Cyclical sectors generally carry wider spreads than relatively stable sectors such as utilities.
• Liquidity: Bonds with lower trading volumes or smaller issue sizes may trade at wider spreads.
• Maturity and structure: Longer maturities generally demand higher spreads.
• Macro conditions: Economic growth, inflation, and policy uncertainty may influence investor risk appetite.
• Market volatility: Higher interest rate or equity volatility may lead to wider spreads.
• Supply and demand: Increased issuance without matching demand may widen spreads, while strong demand may tighten them.
• Recovery expectations and seniority: Higher expected recovery and seniority levels may reduce spreads.

Movements in credit spreads

Credit spreads are dynamic and reflect the market’s changing perception of credit risk.

Widening: Indicates higher perceived risk or lower liquidity.

Narrowing: May suggests improving confidence or stronger demand for credit instruments.

Spreads often move faster than credit ratings, as markets reprice risk in real time. During broad risk-off phases, even higher-rated issuers may see spreads widen. During recoveries, spreads may tighten first in higher-quality issuers and later in lower-rated ones.

How do credit spreads impact bonds?

When risk-free yields remain unchanged, bond prices and credit spreads generally move in opposite directions. If a bond’s spread widens from 120 basis points to 160 basis points, the required yield rises, causing the bond’s price to fall. Conversely, if the spread tightens from 160 basis points to 120 basis points, the required yield falls and the bond’s price rises.

A bond’s total yield equals the risk-free yield plus the credit spread. Portfolio attribution often separates returns into rate and spread components to understand performance drivers.

Read Also: Average Credit Quality: Meaning, Benefits and How it Calculated?

How to calculate credit spread?

To calculate credit spreads consistently:

1. Match maturities: Use the government bond or published G-Sec curve matching your bond’s maturity.
2. Use comparable yields: Take yield-to-maturity on a clean price basis for both bonds, using the same date and time reference.
3. Subtract benchmark yield: Corporate yield minus government yield gives the credit spread in basis points.
4. Adjust for special features: For callable or putable bonds, use the option-adjusted spread (OAS). For amortising or structured bonds, use the zero-volatility (Z) spread based on the full G-Sec spot curve.
5. Track over time: Record historical data to analyse current spreads relative to past levels and peer groups.

Credit spread formula

Credit spread = Yield of credit bond − Yield of matching-maturity government benchmark.

For callable or putable bonds, the option-adjusted spread (OAS) removes the impact of embedded options to provide a cleaner measure of credit risk. For instruments with irregular cash flows, the zero-volatility spread (Z-spread) discounts each cash flow using the government spot curve until the present value equals the bond’s market price.

Example of credit spread

Assume a five-year corporate bond issued by ABC Ltd. yields 7.60%, while the five-year G-Sec yields 6.55%.

• Step 1. Align maturity at five years.
• Step 2. Take same-day yields on clean prices.
• Step 3. Compute spread: 7.60% − 6.55% = 1.05%, or 105 basis points.

If market risk appetite weakens and the spread widens to 135 basis points, the required yield becomes 7.90% (6.55% + 1.35%), leading to a price decline. If spreads later tighten to 95 basis points, the required yield falls to 7.50%, resulting in a price rise. In a Rs. 10 lakh portfolio, even a 30 basis-point movement in spreads may affect mark-to-market value depending on the bond’s duration.

Example for illustrative purposes only

Read Also: Corporate Bonds - How Are They Bought And Sold

Conclusion

Credit spreads summarise multiple risks—such as default, downgrade, and liquidity—into a single, comparable measure. The spread reflects how much extra yield the market demands for assuming credit risk, and its movement may indicate changing market perceptions. Tracking spreads over time, along with fundamental credit analysis, may help investors make relatively informed assessments.

FAQs

How is credit spread defined?

A credit spread is the difference between the yield on a non-government bond and the yield on a government bond of the same or very similar maturity, expressed in basis points.

How do credit spreads affect bond prices?

When risk-free yields are unchanged, wider spreads raise required yields and reduce bond prices, while tighter spreads lower required yields and raise prices. The potential return depends on both interest rate movements and credit spread changes.

What factors influence credit spreads?

Credit spreads reflect several factors including credit quality, leverage, sector risk, liquidity, maturity, macroeconomic conditions, volatility, supply-demand dynamics, recovery expectations, and seniority. Any deterioration may widen spreads, while improvements may tighten them.

What are the practical uses of credit spreads?

Credit spreads are used to assess relative value, compare issuers and sectors, monitor portfolio risk, and evaluate performance attribution between rate and credit effects. Persistent spread widening may prompt investors to review positions, hedge exposure, or re-evaluate portfolio quality.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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