What is Credit Spread?
The Credit Spread is the difference between the yield to maturity (YTM) on a corporate bond issuance and a benchmark rate, most often the yield on a U.S. Treasury note or bond.
By subtracting the risk-free benchmark rate from the yield on a corporate bond, the credit spread represents the “excess”, i.e. the premium earned by the lender, at the expense of the borrower.
How to Calculate Credit Spread
Credit spreads measure the difference in yield between two bond issuances comparable in terms of maturity but with different credit risk profiles.
The credit spread, or “default spread”, is a short-hand method to determine if the expected yield on a corporate bond investment is sufficient, relative to the return received on a risk-free security.
In practice, the credit spread is expressed in terms of basis points (or “bps”), in which 1.0% equals 100 basis points.
Conceptually, the credit spread measures the “excess” return on a corporate bond above the benchmark rate.
Treasuries are securities issued by the U.S. government and the most common benchmark rate to compare against the expected return on a corporate bond issuance.
The debt issued by the U.S. government is considered to be risk-free, since in the improbable scenario wherein default is a material concern, the government can print more money to circumvent the unfavorable outcome of insolvency.
The two most common forms of government debt issuances used to compare against a particular corporate bond include Treasury notes and Treasury notes.
- Treasury Notes (T-Notes) → 2 to 10 Year Term
- Treasury Bonds(T-Bonds) → 20 to 30 Year Term
The appropriate government security to compare the yield on a corporate bond should be the one that matches the maturity (i.e. borrowing term) of the corporate bond.
Credit Spread Formula
The formula used to calculate the credit spread subtracts the benchmark rate from the yield to maturity (YTM) of a corporate bond.
Where:
- Bond Yield → Yield to Maturity (YTM) on Corporate Bond Issuance
- Benchmark Rate → Yield to Maturity of Government Issued Treasuries (e.g. T-Notes, T-Bonds)
The benchmark rate, as stated earlier, is most often the yield on a U.S. Treasury bond.
Note: The credit spread formula assumes a reinvestment at the same rate, while assuming the bond is held until maturity. The computation can become far more complex if variables such as the call provision are considered.
What is a Good Credit Spread?
Since the yield on Treasuries reflects the risk-free rate (rf), the credit spread can interpreted as the incremental compensation earned in excess of the “hurdle rate” by a bondholder.
Fixed income and credit investors actively engaged in the bond market must ensure the yield on the debt security is enough based on the credit risk embedded within the borrowing arrangement (i.e. the “trade-off theory”).
Since the maturities are unlikely to be in perfect alignment and the benchmark rate can fluctuate based on changes in economic conditions, the spread can become skewed.
The core objective of tracking credit spreads in the bond market is to evaluate the risk-return profile of the corporate issuer, which can be a reliable proxy for a potential upcoming wave of defaults (or strong economic conditions).
If the overall creditworthiness of corporate borrowers in the markets is on the lower end, the credit spread tends to widen, warranting higher yields, since lenders must be compensated for the additional risk undertaken (and vice versa).
- Widening Credit Spread → Higher Bond Yield
- Narrowing Credit Spread → Lower Bond Yield
The credit spread can function as an indicator of the economic outlook and sentiment among investors, i.e. if they are optimistic about the near-term performance of borrowers or risk-averse from the increased credit risk (and concerning credit ratings).
Credit Spread Calculator
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
Corporate Bond Credit Spread Calculation Example
Suppose a corporate borrower is raising capital via a bond issuance in 2024.
The borrowing term of the bond is ten years, and a potential investor – the capital contributor interested in providing the debt financing – is anticipated to hold the bond until maturity.
Currently, the benchmark rate of a 10-year Treasury note is 4.00%.
If the estimated yield to maturity (YTM) is 6.0%, what is the credit spread?
The calculation is straightforward, as the only step is the subtract the benchmark rate from the yield to maturity (YTM) of the bond, which results in a credit spread of 0.25%.
- Credit Spread (%) = 6.0% – 4.0% = 2.0% (or 200 bps)
Given the credit spread is 200 basis points, the decision of the lender to proceed with providing the debt capital ultimately boils down to their opportunity cost of capital and appetite for risk, especially since the borrowing term is ten years.
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