Basic, lesson 1 of 3
Credit spreads and what they pay for
A credit spread is the extra yield over a Treasury for lending to a company instead of the government. Part of it covers the losses you expect, and the rest pays you for illiquidity and for bearing the risk at all.
9 min, 3 checks
1The spread, in one subtraction
A corporate bond's spread is its yield minus the yield of a Treasury with about the same maturity. If Corvane Industries' 5 year bond yields 5.60% and the 5 year Treasury yields 4.10%, the spread is 150 basis points. The Treasury part is the price of money. The spread is the price of Corvane.
Credit spread = Corporate bond yield - Treasury yield (same maturity)
Quoted in basis points. 1bp = 0.01%.
Spreads and Treasury yields can move in opposite directions on the same day. A risk off morning often sees Treasury yields fall while spreads widen, so an investment grade bond's all in yield barely moves while a Treasury rallies.
2Expected loss: the part of the spread that is not profit
If a company defaults, bondholders usually recover something. Loss given default (LGD) is 1 minus the recovery rate. The yearly loss you expect is the default probability times the LGD. A spread has to cover at least that, or lenders lose money on average.
Expected annual loss = Default probability x (1 - Recovery rate)
Rearranged: implied default probability = Spread / (1 - Recovery). This treats the whole spread as default risk, so it overstates the true probability.
Worked example
Splitting Corvane's 150bp
- 1Assume a 2% annual default probability and 40% recovery, so LGD is 60%.
- 2Expected loss: 2% x 60% = 1.20%, or 120bp.
- 3Spread: 150bp. Left over: 150 - 120 = 30bp.
- 4Those 30bp pay for illiquidity (the bond is harder to sell than a Treasury) and for bearing the risk that defaults cluster in a bad year.
Only 120bp of the 150bp is compensation for losses you expect. The 30bp is the premium, and it is what a long credit position earns on average if the default estimate is right.
Check 1
A bond's issuer has a 1.5% annual default probability and recovery is assumed at 40%. What is the expected annual loss, in basis points?
Check 2
A high yield bond trades at a 400bp spread and recovery is assumed at 25%. If the whole spread were default risk, what annual default probability would it imply, in percent?
3Ratings and the line that matters
Rating agencies grade issuers. The line that moves money is between investment grade and high yield, because many pension funds, insurers, and index funds can only own investment grade. A downgrade across that line forces selling.
| Band | Ratings | What it means for a trader |
|---|---|---|
| High grade | AAA to A- (Aaa to A3) | Trades on rates and supply more than on company news |
| Low investment grade | BBB+ to BBB- (Baa1 to Baa3) | The biggest bucket by size; downgrade risk is the story |
| High yield | BB+ to B- (Ba1 to B3) | Trades on earnings, leverage, and refinancing; quoted in price |
| Distressed | CCC and below (Caa and below) | Trades on recovery value; more like equity than a bond |
Check 3
Which rating is the lowest that still counts as investment grade on the S&P scale?
Spread duration links a spread move to a price move, the same way duration links a yield move to a price move. A bond with spread duration 6 loses about 6 x 0.50% = 3% of its price if its spread widens 50bp, even with Treasuries unchanged.
Terms in this lesson: Credit spread, Basis point, Credit rating, Duration, Treasury securities.
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