Credit spread
The extra yield of a corporate bond over government debt: a gauge of default risk.
The price of default risk
The credit spread is the extra yield a corporate bond offers over a government bond of the same maturity. It pays for default risk and lower liquidity. It is small for solid companies (investment grade) and larger for high yield.
Source: ICE BofA US High Yield (FRED), rounded peaks.
A stress thermometer
Spreads widen when investors fear a recession or a financial crisis, and tighten when risk appetite returns. A sharp widening often precedes or accompanies equity sell-offs.
Worked example
Reading a spread
- The 5-year government bond yields 3.0%, a corporate bond of the same maturity 4.8%.
- Spread: 4.8 - 3.0 = 1.8 points, i.e. 180 basis points.
- Typical of a BBB to BB rating.
The investor earns 1.8% a year for taking this company’s risk.
Common mistakes
- Taking a wide spread for a bargain: it pays for real default risk.
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