Credit Spread: What It Means for Bonds and Options Strategy

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Credit Spread: What It Means for Bonds and Options Strategy

What is a Credit Spread?

A credit spread is the yield differential between a US Treasury bond and another debt instrument with the same maturity but a different credit grade. Credit spreads between US Treasury bonds and other bond issuances are measured in basis points, with a 1% difference in yield equaling a 100 basis point spread. A credit spread of 200 basis points is reported to exist between a 10-year Treasury note with a yield of 5% and a 10-year corporate bond with a yield of 7%. Bond spreads and default spreads are other terms for credit spreads. The credit spread compares a corporate bond to a risk-free alternative.

A credit spread is also a method in which a high premium option is written and a low premium option is purchased on the same underlying asset. This results in a credit to the account of the individual who made the two deals.

Credit Spread

Understanding Credit Spreads (bonds and options)

Credit Spread for Bonds

Bond credit spreads represent the yield differential between a government bond and a corporate bond of the same maturity. Because it is risk-free and guaranteed by the full confidence and credit of the United States government, debt issued by the United States Treasury is used as a benchmark in the financial sector. Treasury (government-issued) bonds in the United States are regarded the closest thing to a risk-free investment since the danger of default is nearly non-existent. Investors are quite certain that they will be compensated.

Even for the most stable and highly rated corporations, corporate bonds are regarded risky investments for which the investor wants compensation. The credit spread serves as this compensation. To instance, if a 10-year Treasury note yields 2.54% and a 10-year corporate bond yields 4.60%, the corporate bond gives a 206 basis point premium over the Treasury note.

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Bond Credit Spread = (1 – Recovery Rate) * (Default Probability)

Credit spreads differ from one security to the next dependent on the credit rating of the bond’s issuer. Higher-quality bonds, which have a lesser risk of default, might provide lower interest rates. Lower quality bonds, which have a larger risk of default, must provide higher interest rates to entice investors to the riskier investment. Changes in credit spreads are often caused by changes in economic circumstances (inflation), changes in liquidity, and demand for investment within certain markets.

When confronted with unclear to deteriorating economic circumstances, for example, investors prefer to flock to the protection of U.S. Treasuries (purchasing), frequently at the price of corporate bonds (selling).This dynamic leads US Treasury bond prices to climb when rates decrease, whereas corporate bond prices fall while yields rise. The widening reflects investor anxiety. This is why credit spreads are often a useful indicator of economic health, expanding (poor) and narrowing (good) (good).

Bond market indexes are used by investors and financial specialists to monitor the yields and credit spreads of various forms of debt with maturities ranging from three months to 30 years. High Yield and Investment Grade US Corporate Debt, mortgage-backed securities, tax-exempt municipal bonds, and government bonds are among the most prominent indices.

Credit spreads are wider for debt issued by developing markets and lower-rated firms than for debt issued by governments and richer and/or more stable countries. Bonds with longer maturities have wider spreads.

Key Takeaways

  • A credit spread is the yield differential between a government bond and a corporate bond of the same maturity.
  • Bond credit spreads are often an useful indicator of economic health, broadening (poor) and narrowing (positive) (good).
  • A credit spread is also a method in which a high premium option is written and a low premium option is purchased on the same underlying asset.
  • A credit spread options strategy should result in a net credit, which is the trader’s maximum profit.
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Credit Spreads as an Options Strategy

A credit spread is also a form of option strategy in which the trader buys and sells options with the same type and expiry date but different strike prices. Premiums received should exceed premiums paid, resulting in a net credit for the trader. The net credit is the maximum profit that trader can make. The bull put spread, in which the trader expects the underlying security to rise, and the bear call spread, in which the trader expects the underlying security to fall, are two examples of such techniques.

A bear call spread would consist of purchasing a January 50 call on ABC for $2 and writing a January 45 call on ABC for $5. The trader’s account earns $3 per share (each contract represents 100 shares) after receiving a $5 premium for writing the January 45 call and spending $2 to acquire the January 50 call. If the underlying security’s price is at or below $45 when the options expire, the trader has profited. This is referred to as a “credit spread option” or a “credit risk option.”

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