Credit Spreads

Why this matters

Credit Analysis ended with a hurdle: on forty years of default data and an assumed recovery, a B-rated bond has to yield about two points more than a Treasury just to break even. That raises the obvious next questions. How much more do such bonds actually yield? Is it enough? And what happens to a bondholder when the market changes its mind? All three are questions about the credit spread, which is to corporate bonds what the yield is to Treasuries: the number that sums up the price of the risk.

Measuring a spread

The difference between the yields of two bonds is called a spread, and it's usually stated in basis points, each a hundredth of a percentage point. The difference between a bond's yield and that of a Treasury of the same maturity is its credit spread.¹

Credit spread = Bond's yield − Yield of a Treasury of the same maturity

A 7-year corporate bond yielding 6.4% when the 7-year Treasury yields 5.1% has a spread of 1.3 points, or 130 basis points. Treasuries are the reference because their payments are taken as certain, so whatever a corporate bond yields beyond them is the market's price for everything else about it.¹

Published spreads for whole categories of bonds are usually option-adjusted spreads, which allow for features like an issuer's right to call a bond, and are averaged across an index of bonds in a rating category.² For a plain bond with no such features, the option-adjusted spread and the simple one above are close to the same thing.

What's inside a spread

A spread has to cover the losses a lender expects from defaults. If that were all it covered, corporate bonds would on average earn the same as Treasuries, with more risk, and nobody would hold them. So spreads also carry a credit risk premium: a reward for bearing the risk.

Credit spread = Expected loss from default + Credit risk premium

Rating group	Spread over Treasuries	Rough yearly expected loss	What's left
BBB	1.02	0.17	0.85
BB	1.88	0.72	1.16
B	3.10	2.02	1.08
CCC and below	12.53	7.09	5.44

In percentage points. Spreads are index option-adjusted spreads from ICE Data Indices.² Expected losses are the figures worked out in Credit Analysis from S&P's five-year default rates for 1981 to 2023,³ with a 40% recovery assumed. The two come from different sets of bonds, so the last column is an illustration and not a measurement.

At each rating the spread was larger than the historical loss, by about a point for most of the scale. That pattern isn't special to one day. A study of the US corporate bond market from 1866 to 2008 found that, over the long term, credit spreads were roughly twice as large as default losses, leaving an average credit risk premium of about 80 basis points.⁴

Why would investors be paid more than the losses they suffer? The lessons so far suggest three reasons, none of which shows up in an average.

• Defaults arrive together. The speculative-grade default rate was under 2% in some years and around 10% in others.³ A loss that comes in the same year as a recession and a fall in shares hurts more than its average size suggests.
• The upside is capped. A bond can lose most of its value and can never return more than its promised payments. Investors want extra for an asset with small gains and occasional large losses.
• Corporate bonds are harder to trade. How Bonds Are Quoted and Traded covered why, and why that gets worse in exactly the periods when people want to sell.

The premium is an average over long periods. It isn't a promise for any one of them, and the same study found that spreads didn't adjust in response to the default rates that had actually occurred.⁴ A wide spread is no guarantee of a good outcome, and a narrow one is thin protection.

The rest of this lesson is for members

Still to come in this lesson: Forty years of one spread, What a wider spread does to a bond, Reading a spread as a probability, the key takeaways, and 2 quiz questions with explanations.

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