Credit Spreads

Two bonds mature on the same day in five years. One is issued by the US Treasury and yields $4.2\%$. The other is issued by a mid-sized manufacturer and yields $6.2\%$. Same maturity, same currency, same cash-flow shape, and yet one pays two percentage points more than the other. That gap, $2\%$ or 200 basis points, is the credit spread.

It is the same instinct you already have about lending to people. You would lend your neighbour money at a higher rate than you would lend a bank, not because you are certain your neighbour will stiff you, but because you are less sure. The spread is the price of that lack of certainty, quoted in yield.

How the spread is measured

The crude version is a straight subtraction: the bond's yield minus the yield on a government bond of similar maturity. That is the G-spread, and it is fine for a quick read, but it compares a single yield number against a single point on a curve.

Serious desks use the Z-spread instead: the constant amount you must add to every point of the government curve so that the discounted cash flows equal the bond's market price. It handles odd maturities and steep curves correctly, and Z-Spread and I-Spread covers the mechanics. If the bond is callable, you strip out the value of that embedded option first and quote an option-adjusted spread, so you are comparing the credit risk and not the borrower's right to refinance.

Worked example: what default rate is the spread implying?

Spreads and default probabilities are linked by an approximation credit traders use constantly, the credit triangle:

$$s \approx h \times LGD,$$

where $s$ is the spread, $h$ is the annual hazard rate (the chance of defaulting this year given survival so far), and $LGD$ is the fraction lost when default happens. In words: the yield you are paid each year should roughly match the loss you expect each year.

Run it on our manufacturer. The spread is $s = 2\%$. Senior unsecured recoveries average around $40\%$, so $LGD = 60\%$. Then

$$h \approx \frac{0.02}{0.60} = 0.0333,$$

about a $3.3\%$ chance of default per year. Now check that against reality: actual one-year default rates for a comparable BB-rated issuer sit nearer $1\%$. The market is charging you for roughly three times the default risk that history suggests. That excess is not stupidity, it is the credit risk premium plus a liquidity charge, and it is exactly why buying credit has been a profitable long-run trade despite defaults. See The Credit Triangle: Spread, Hazard Rate and LGD.

Worked example: spread moves are what hurt you

Suppose you buy that bond and nothing defaults. Are you safe? No, because spreads themselves move. The sensitivity is spread duration: the percentage price fall per one percent of spread widening. Our five-year bond has a spread duration of about $4.5$.

Hold it for a year and collect $2\%$ of spread income. If the spread widens from 200bp to 250bp, the price falls by roughly $4.5 \times 0.5\% = 2.25\%$. Net result: $2\% - 2.25\% = -0.25\%$. You were right about default and still lost money. Flip it and the maths is just as useful: your breakeven widening is the spread divided by spread duration, $2\% / 4.5 = 0.44\%$, so spreads can drift 44bp wider over the year before your carry is wiped out. That single ratio is how credit relative-value traders size positions.

What this means in practice

Aggregate spreads are one of the most reliable business-cycle gauges in finance. Investment-grade spreads sit near 100bp in calm markets and blow past 500bp in a crisis; high yield goes from roughly 350bp to well over 1,000bp. They widen before recessions and before equity markets react, which is why macro desks watch credit indices as a risk-appetite thermometer rather than as a bond-picking tool. And because spread is quoted separately from the government curve, a credit fund can hedge out interest-rate risk entirely and hold nothing but a view on the borrower.

Key terms

• Credit spread — yield above a risk-free bond of the same maturity, quoted in basis points.
• G-spread / Z-spread / OAS — spread over a matched government yield, over the whole curve, and after stripping embedded options.
• Hazard rate — annual chance of default given survival so far.
• Credit triangle — the rule of thumb that spread is approximately hazard rate times loss given default.
• Spread duration — percentage price change per one percent move in spread.