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Credit spreads, sometimes referred to by the name of a yield spread refers to the yield difference between two bonds that have similar maturity, but with different credit quality. Spreads on credit are calculated in percentage points with a one percent difference in yield equal to 100 basis points.
For instance an example, a 10-year Treasury note that has 5 percent yield and a corporate bond of 10 years with an interest rate of 7% are believed to have an average credit spread of 200 basis points. Credit spreads can also be called “bond spreads” or “default spreads.” Credit spreads permit an analysis of the corporate bond and a risk-free option.
A credit spread could be used to describe an options strategy in which an extremely high cost option is written , and an option with a lower premium is purchased from the same security. This gives a credit your account from the person who made both trades.
Credit Spread for Bonds
A spread of credit on bonds is the difference in yield between a corporate and treasury bond with the same time. Treasury-issued debt from Treasury of the United States Treasury is used as a standard for the financial market because of its risk-free status , which is backed by the complete credit and faith from the U.S. government. US Treasury (government-issued) bonds are considered to be the most secure to a secure investment because the chance of default is nearly non-existent. The investors have complete confidence in being repaid.1
The corporate bonds that are offered, even for highest-rated and stable companies are considered more risky investments and the investor is required to pay compensation.2 The compensation for this is called the credit spread. For example the situation, suppose the 10 year Treasury note has an interest rate of 2.54 percent, whereas the corporate bond of 10 years has an interest rate of 4.60 percent The corporate bond has an interest rate of 206 basis point over those of the Treasury note.
Credit Spread (bond) = (1 – Recovery Rate) * (Default Probability)
Credit spreads differ between the different securities dependent on the credit rating of the person who issued the bond. Bonds with higher quality, which have a lower chance of the issuer defaulting, could provide lower interest rates. Low-quality bonds, with a greater risk of defaulting by the issuer and requiring more interest rates in order to lure investors to the more risky option. The fluctuation in credit spreads is usually caused by fluctuations in the economic environment ( inflation) and changes in liquidity and the demand for investment in certain markets.
For instance, when confronted with deteriorating economic conditions , investors are likely to escape to the security from the security of U.S. Treasuries (buying) usually at the expense corporate bond prices (selling). This is a cause for US Treasury prices to increase while the yields to drop as corporate bond prices drop and yields increase. The rise in yields is indicative of concern from investors.
Credit Spreads as an Options Strategy
A credit spread could also be used to describe a type of option strategy in which the trader buys and then sells options of the same kind and expiration, but at various strike price. The amount of premiums earned must be higher than the cost of the premium, which results to a credit net to the trader. Net credit is the most profits that the trader can earn. Two strategies that can be used include those that use the bull put spread in which traders expect the security that is being traded to rise and the bear call spread that is where the trader is expecting the security’s fundamentals to decrease.