A deeper look at credit spreads

In an earlier article this year, I remarked that the paradox of bond prices rising as interest rates rise could be explained by falling credit spreads. So, today I want to delve a little bit more into the usefulness of credit spreads and their importance to bond investors.

What is a credit spread?

A credit spread can be viewed as an indicator of the relative risk of default between a risky bond and a “risk-free” alternative and is calculated as the difference between their yields. The “risk-free” rate is the usually obtained from a government yield curve. For instance, the applicable “risk-free” rate for companies issuing bonds denominated in Jamaican dollars would be the GOJ JMD yield curve while corporates issuing in debt denominated into Brazilian Reals would use the Brazilian government yield curve for Reals. For USD denominated bonds, regardless of the country of issuance, the “risk-free rate” is obtained from the U.S. Treasury bond curve. This therefore allows for a comparison of credit spreads for corporates as well as sovereigns issuing debt in USD.

Credit spreads are measured and expressed in basis points (bps) where 1bp is equal to 0.01 percentage point, i.e., 1bp = 0.01%. As an example, a 10-year USD corporate bond with a yield of 2.5% will have a credit spread of 100bps when compared to U.S. 10-year Treasury bond at a yield of 1.5%. Credit spreads are also referred to as "bond spreads" or "default spreads" and provide a representation of the perceived credit risk or the risk that an issuer will default on bond payments. Hence, the smaller the credit spread is the lower is the perceived risk of default. Consequently, investment grade rated bonds usually have lower credit spreads than non-investment grade rated bonds.

Importance and usefulness of credit spreads to bond investors

For corporate bond investors one of the most important points of discussion is credit spreads. Credit spreads are the industry benchmark for the risk premium an investor aims to earn in the corporate bond market. If spreads are falling it is positive for investors as the price of the corporate bond should increase; likewise, a widening of credit spreads usually leads to a lower bond price.

Credit spreads are also useful in assessing investor sentiment. For example, if investors are uncertain about the future, they will turn to the safety of U.S. Treasuries. This demand then causes the price of U.S. treasuries to rise, leading to a decrease in their current yields and thus causing credit spreads to widen. This can be then interpreted as a sign of investor uncertainty.

Credit spreads also allow investors to assess the relative risk of investing in different bonds whether within the same industry/sector/country or bonds from different industries/sectors/countries. If spreads are relatively widening within an industry, this could mean that the industry is underperforming and perhaps should be avoided, while narrowing spreads within an industry suggest outperformance and less perceived credit risk. Additionally, if a bond within the same industry has a credit spread that is twice that of another similar maturing bond within the same industry, then the former is perceived to be twice as likely to default than the latter. 

Finally, credit spreads can also be used as part of a trading strategy. Like other type of traders, bond traders are seeking to buy low and sell high. As it relates to credit spreads, this translates into purchasing when spreads are wide and selling when they are narrow. However, this approach can be very risky as there may be factors unknown to the investor and should therefore only be practiced by highly skilled or very experienced bond traders.

Eugene Stanley is the VP, Fixed Income & Foreign Exchange at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual, and institutional investor. Visit our website at www.sterling.com.jm

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