The spread of a bond, also called credit risk premium, helps us assess the level of credit risk in companies and countries. We analyze what bond spreads are, how they correlate with higher potential returns, and how to use them even if we do not invest in bonds.
Content
- Introduction
- How are Bond Spreads Calculated?
- What do Bond Spreads tell us?
- What the Credit Spread is Compensating Investors for
- Importance of Bond Credit Spreads
- Conclusion
Introduction
The spread of a bond is the difference between the yield on that bond and the yield on a bond considered credit risk-free. Sometimes credit spreads can also be calculated relative to swap rates. However, we will focus on spreads relative to risk-free bonds since they are easier to understand and more common.
The risk-free bond used for the calculation of a bond’s credit spread will be a government bond issued in the same currency and maturing at around the same time. This is known as the benchmark. Every bond with credit risk will have its own risk-free benchmark bond. Though government bonds can be used as benchmark for many different bonds.
In the case of US Dollar-denominated bonds, we will select a US Treasury Bond maturing at a date that is close to the maturity date of the risky bond. In the case of Japanese Yen-denominated bonds, we will select a Japanese Government Bonds. And, if the bond is denominated in Euros, we will pick a German government bond.
The yield of a bond is the return that we can expect from that bond if we hold it until maturity, there is no default, and we reinvest all coupon payments at the same rate. It can be described as the return we can expect if everything goes well, and the borrower is able to repay its debts. If you want to learn more about the exact formula used to calculate the yield of a bond, check out this link:
Bond Yields – Fundamental Metric for the Fixed Income Market
How are Bond Spreads Calculated?
Bond spreads are very easy to calculate. We just have to look at the yield of our bond and subtract the yield of the benchmark bond. For example, if a corporate bond has a yield of 5% and the benchmark bond has a yield of 3%, the credit spread, or risk premium, will be 2%. 2% can also be expressed as 200 basis points.
Spreads are usually indicated in basis points. One basis point corresponds to 0.01%. Thus, a spread of 40 basis points would be 0.4%. And a spread of 400 basis points would be 4%. Spreads can be calculated for government bonds too.
For example, if the yield on a 10-year Spanish government bond is 3.5% and the yield on a 10-year German government bond is 2.3%, the Spanish government bond has a credit spread of 1.2%, or 120 basis points.
What do Bond Spreads tell us?
The credit spread indicates the additional annual return that we can expect from investing in a bond with credit risk if everything goes well. If we stick to our previous example, the Spanish government bond yields 1.2% more per annum than a similar German government bonds.
Consequently, if Spain is able to pay its debts over the next 10 years, we can expect to make roughly 12% more investing in the Spanish bond than if we invested in the much safer German government bond.
That extra yield, indicated by the credit spread, compensates investors for the additional risks they are taking on.
What the Credit Spread is Compensating Investors for
Before determining whether a credit spread is high enough to compensate us for taking on that additional risk, we must ask ourselves what exactly the credit spread is compensating us for.
In general, there are two types of risk for which we must be compensated when investing in a riskier bond relative to a credit risk-free bond:
- Credit Risk: this is the risk that the borrower may experience financial difficulties in the future. This can lead to two potential negative scenarios. One would be an outright default in which the borrower declares bankruptcy, debt has to be restructured, and we loss a large percentage of our investment, if not everything. The other type of credit risk is simply a deterioration in the financial state of the borrower. That would lead to the credit spread becoming wider which will lead to a lower bond price, therefore making us suffer an immediate loss even if no default has occurred.
- Liquidity Risk: this is the compensation we may get for investing in bonds that are difficult to trade. Not all bonds pay a liquidity risk premium, as some bonds with credit risk as very liquid. However, bonds with little liquidity have to compensate investors for the potential difficulty they may experience if they ever want to sell the bond.
Importance of Bond Credit Spreads
Whether you invest in individual bonds or, as is probably more convenient, through mutual funds and ETFs, credit spreads are a key metric to consider.
The yield on a bond or bond fund can always be broken down into two parts. The first is the risk-free part, which is what we would get by investing in US Treasury bonds in the case of US Dollars, o German government bonds for Euros.
The second is what we get by investing in bonds with credit risk and, to a lesser extent, liquidity risk.
Bonds with high credit spreads offer higher potential returns but can also suffer large losses. In general, risky bonds tend to perform well when the economy is strong and poorly when the economy is heading into a recession.
When you invest in bonds, you can make money in two ways. The first is by simply holding the bond. That return is mostly determined by the yield of the bond and is known as carry.
We can also make money when the price of the bond increases in price. This can happen if either interest rates or credit spreads go down.
Conclusion
The credit spread of a bond is one of the key metrics when analyzing fixed income instruments such as bonds. The bond yield tells us about its expected return under positive circumstances. Duration tells us about the bond’s interest rate risk. And the credit spread tells us about the level of credit risk embedded in that bond.
Credit spreads are closely related with credit ratings. If you would like to learn more about that, check out the following link:
The Credit Ratings for Bonds
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