What is a Credit Spread?
Credit spread is a term with a couple of different meanings in the world of investing. Specifically, it has applications in both the bond market and in the context of derivative investments like options. Investors active in these markets need to get familiar with the concept, to ensure they’re approaching investments with a thorough understanding of how to profit from them.
Here’s a quick overview of credit spreads in the context of both types of investments, as well as how to use this information to make good decisions about investments.
Credit Spreads in the Bond Market
In the bond market, credit spreads refer to the difference in yield between two bonds that are exactly the same but carry a different interest rate. Investors measure the spread of these differences in percentages, which are then converted to basis points. For example:
ABC Company issues a 10-year bond with a 6% interest rate. Meanwhile, XYZ Company issues a 10-year bond with an 8% interest rate. The credit spread between these two bonds is 2%, represented as 200 points.
Usually, bond investors will measure the credit spread between a corporate bond and a “risk free alternative,” such as a U.S. Treasury. In the above example, an investor might compare the credit spread of these bonds to a 10-year Treasury Note with an interest rate of 5%. This results in a 100-point and 300-point spread, respectively.
When comparing the spread between a corporate bond and a U.S. treasury bond, the spread is a benchmarking tool. Since treasuries are a risk-free standard, the spread represents the level of risk an investor assumes in seeking a higher interest rate. Usually, a high interest rate offsets a lower credit rating, which signifies risk.
Comparing the spread between corporate bonds is also a measure of risk, albeit one that only contextualizes the bonds in question. Investors might do this as they consider the risk-reward relationship between two corporate bonds.
In the bond market, wider credit spreads signal a higher level of risk. Narrow credit spreads signal relatively low risk, especially between corporate bonds and treasuries.
Credit Spreads in the Derivatives Market
If you’re looking to trade vertical option spreads, your setup will either amount to a debit or a credit. A credit spread occurs when investors sell an option with a high premium and purchase an option with a low premium. The net difference is the credit, and it’s equivalent to the maximum profit the investor can make from the spread. This assumes both options pertain to the same underlying security and the same time horizon.
There are many different ways to set up a credit spread when trading options. Two of the most common include:
- Bull put spread. This vertical options strategy involves buying one put option while simultaneously selling another put option for a higher strike price. The investor nets the difference between the two puts. A bull put spread is a bet that the price of a stock will moderately increase in the near-term.
- Bear call spread. This vertical options strategy is a bet that the price of a stock will go down in the near term. It involves two call options: buying a call option at a low price while selling another call option at a lower strike price. Again, the net profit from this strategy represents the maximum ROI possible.
In the case of any credit spread, traders realize their profits upfront. However, based on the behavior of the underlying stock price, those profits have the potential to shrink up to the point another trader exercises the sold option. Traders know their maximum profits and losses upfront; however, realized profits may vary within that range.
Calculate Credit Spreads Before Opening a Position
Whether in the context of bonds or options, investors need to calculate credit spreads before they jump into a position.
In the case of bonds, credit spreads are the quickest way to assess the potential risk of one particular bond over another. For example, if the credit spread between a corporate bond and a U.S. treasury is 100 points, it’s a sign of very little risk. However, if the spread between two corporate bonds is 400 points, investors need to think about the amount of risk they’re willing to assume.
For options traders, credit spreads are a great way to collect potential profits upfront. Taking in a net profit to set up a spread gives traders access to funds instantly, which they can use to make other investments during the term of an options contract. And, because traders can only lose the setup cost, they’re prepared in the event the contracts expire worthless. It’s the perfect vertical spread strategy for investors who want to know all the variables upfront.
In both instances, understanding the credit spread is a vital precursor to investment. Take some time to consider it before investing in a bond or setting up a vertical option spread.
Credit Spreads Lay Bare Investment Potential
The beauty of assessing credit spreads is that investors can gauge key variables upfront, before they invest. What level of risk are you willing to accept from a bond you plan to hold to term? Is the profit from a particular credit spread worth the setup? Analyzing spreads upfront lays bare the investment potential and helps investors make better decisions about where to put their money.