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Credit Spread (Bonds and Options)
In finance, a credit spread refers to the difference in the yields (returns) of two investment or financial instruments with the same maturity but different credit quality. Credit or yield spread often occurs as a result of the difference in credit qualities which indicates that one instrument has a risk premium over the other. For instance, the difference between the yield of a U.S. Treasury bond and another debt security such as a corporate bond is called a credit spread.
Credit spread is also used in the context of options strategy to describe a situation where a high premium option and a low premium option is written and bought respectively on the same security.
A Little More on What is Credit Spread
Credit Spread for Bonds
Credit spread for bonds reflects the difference in the yield or return of two bonds with the same maturity but different credit quality. Such as a Treasury bond issued by the U.S Treasury and a corporate bond issued by a corporation. In this scenario, the Treasury bond has a higher credit quality because of its risk-free nature, while corporate bond has a degree of risk such as default risk. The difference in the yields between these two bonds is known as a credit spread.
Credit spreads are measured in basis points, it takes a 100 basis points to give a 1% credit spread. Hence, if a 5-year U.S. Treasury note trades at a yield of 8% and a 5-year corporate bond trades as a yield of 10%, the credit spread between the two is 2%, giving 200 basis points.
Credit Spread (bond) = (1 – Recovery Rate) * (Default Probability)
The credit rating or quality of the issuer of a bond is a determinant of the credit quality of such bond. While the United States is considered the benchmark for bonds because it is risk-free, there are many corporate bonds offered by a reputable corporation and have a minimum degree of risks. The higher the credit quality of a bond, the lower the risks and chances of default and vice versa.
Aside from the difference in the credit quality of bonds that cause a difference in yield, credit spread can also occur due to general market fluctuations such as liquidity chance, inflation, demand, and other economic factors. There are several ways through which financial experts track credit spreads in bonds and other debt securities.
The important points to note about credit spread include the following;
- A credit spread refers to the difference in the yield of two debt securities with the same maturity but different credit quality.
- The difference in the credit quality of the securities indicates their levels of risks, thereby resulting in credit spreads.
- Economic wellness can also reflect in credit spread, in the sense that when there is good or bad economic health, it tells on credit spread.
- Credit spreads are measured in basis points, 100 basis points give 1% credit spread.
Credit Spreads as an Options Strategy
When used as an options strategy, a credit spread creates a situation in which a trader has a high premium option written and a low premium option bought on the same security. This strategy often results in a maximum profit for a trader, otherwise known as the net credit. Using credit spreads as an options strategy can either be through the bull put spread or the bear call spread.
In a bull put spread, the trader forecasts that the price of the underlying security will increase, while in a bear call spread, the price is expected to decrease.