Credit spreads

Credit spreads

Credit spreads stand out as the unsung hero of investment analysis in the complex world of finance, where risk and reward dance a never-ending tango. These seemingly innocuous number differences are crammed full of knowledge that indicates the complex web of market emotion, credit quality, and economic expectations. Credit spreads, which act as risk and reliability indicators and lead investors through the complex web of bonds, loans, and options, silently unfold as the financial markets rise and fall. Here, we explored the subtleties, workings, and relevance of credit spreads to resolve the mystery surrounding them. 

What are credit spreads? 

A credit spread is a change in yield or interest rates between two financial securities with comparable maturities but varying credit quality. It quantifies how much money investors want in return for taking on the extra risk of investing in a lower-quality debt instrument instead of a higher-quality one. The basic tenet of the idea is that safer borrowers can provide lower yields due to their perceived lower risk, while riskier borrowers could offer greater yields to draw investors. 

Understanding credit spread 

Let’s dissect the elements of credit spreads to understand them better: 

  • Yield 

The income produced by an investment is known as yield and is often stated as a percentage of the investment’s value. Both interest payments and possible capital gains or losses are included. 

  • Credit Quality 

A borrower’s capacity to meet debt commitments is gauged by credit quality. Credit rating organisations like Moody’s, Standard & Poor’s, and Fitch evaluate it based on financial indicators and other pertinent data. 

  • Risk and Return 

Investors demand rewards in exchange for taking on more significant amounts of risk. Credit spreads reflect this compensation; risk perception increases and decreases in width as risk perception falls. 

Working of credit spread 

The intricate balance between risk and reward in the financial environment determines how a credit spread operates. The spread is the numerical link between two debt securities with equal maturities but different credit quality. The spread varies when investors evaluate a borrower’s creditworthiness to account for perceived risk. Investors request a more significant yield when a borrower with a higher risk of default issues a debt instrument. The spread between the lower-quality debt instrument and a benchmark, like a government bond, widens due to the elevated yield. In contrast, investors accept a lower yield when a lower-risk borrower enters the picture, resulting in a narrower spread. 

Due to its dynamic nature, the credit spread reflects the ups and downs in market sentiment and economic situations. Risk perceptions drive a complex dance that steers investors towards profitable opportunities while protecting them from potential pitfalls. 

Types of credit spread 

Corporate Bonds and Option Spreads are the two basic types of credit spreads. 

  • Corporate bond spreads 

These spreads evaluate the credit risk of such bonds. The primary types consist of: 

  • Benchmark Spread 

The variation in yield between a corporate bond and a benchmark government bond of comparable maturity. 

  • Intermarket Spread 

The variation in yields across comparable bonds issued in various markets or industries. 

  • Option spreads 

These spreads, which incorporate options contracts, are employed to control risk or make predictions about future market trends. They consist of trades like the bull put spread and the bear call spread, which attempt to make money off changes in the underlying asset’s value. 

Example of credit spread 

Let’s use the following example to illustrate the significance of credit spreads: 

A tech firm named Company X chooses to issue bonds to finance money. The bonds of Company X have a Baa3 credit rating from Moody’s because of its relatively inexperienced track record. However, Company Y, a well-known market leader, earns an Aa2 bond credit rating. The bonds of Company X offer a yield of 6% at the time of issuance, while the bonds of Company Y offer a yield of 3%. It suggests a 3% credit spread between the two bonds. Investors want this larger yield from its bonds to make up for the extra risk brought on by Company X’s lower credit rating. 

In this case, the credit spread reflects both the market’s estimation of each firm’s risk and the difference in credit quality between the two companies. It also shows how credit spreads can gauge market sentiment and a borrower’s perceived stability. 

Frequently Asked Questions

A credit spread can be bullish or bearish, depending on its type. A bullish credit spread seeks to increase the underlying asset’s price by simultaneously selling a lower strike and buying a higher strike option. This strategy is positive since it benefits from a modest price gain and has little risk. 

The yield of a riskier debt instrument is subtracted from a benchmark yield using the credit spread formula. Typically, it is as follows: 

Credit Spread = Benchmark Yield – Yield of Riskier Debt Instrument 

The premium investors’ demand for holding higher-risk debt can be calculated using this method. While a narrower spread suggests lower risk and more excellent creditworthiness, a broader spread suggests higher perceived risk. 

Bond prices and credit spreads are related in the opposite direction. Lower-quality bonds’ prices decline as demand declines and credit spreads widen due to higher perceived risk. On the other hand, when credit spreads contracts due to better credit conditions, there is a greater demand for lower-quality bonds, which drives up prices. Thus, credit spreads impact the market’s perception of and pricing for bonds. 

A credit spread in bonds is the difference in yield between two bonds, one of lower credit quality (like a corporate bond) and one of more excellent credit quality (like a government bond). It gauges the greater return that investors demand in exchange for assuming the increased risk of the lower-quality bond. A broader credit spread indicates higher perceived risk, whilst a smaller spread indicates lesser risk. 

Yes, a credit spread approach might result in financial loss. The value of the spread may decline, incurring a loss, if the market moves oppositely from what is anticipated. Furthermore, possible losses may outweigh potential returns if the spread is not adequately controlled. Trading credit spreads requires an understanding of and ability to manage risk. 

    Read the Latest Market Journal

    Financial Sectors Thriving: Top Traded Counters in April 2024

    Published on May 21, 2024 29 

    At a glance: The Federal Reserve (Fed) held interest rates steady at 5.25% to 5.5%...

    One Dollar at a Time: The Potential of Fractional Shares

    Published on May 20, 2024 48 

    Table of contents 1. Introduction 2. Dollar-Cost Averaging 3. Popularity of Dollar-Cost Averaging 4. Small...

    Unit Trusts vs Exchange Traded Funds (ETFs) – Which is better for your portfolio?

    Published on May 20, 2024 46 

    Imagine you are dining at a nice restaurant, feeling overwhelmed by the variety of seemingly...

    Weekly Updates 20/5/24 – 24/5/24

    Published on May 20, 2024 18 

    This weekly update is designed to help you stay informed and relate economic and company...

    What is CFD? With 2 Practical Examples

    Published on May 15, 2024 102 

    In this article, you will learn what CFD (Contract for Difference) is, the costs and...

    What is ESG investing, and why is it important?

    Published on May 15, 2024 96 

    Over the last five years, Environmental, Social, and Governance (ESG) investing has evolved from being...

    What are fixed-income funds?

    Published on May 15, 2024 51 

    In the diverse world of unit trusts, various funds employ distinct investment strategies aligned with...

    Hong Kong Value Stocks Q2 2024

    Published on May 14, 2024 124 

    After a long period of sluggishness, Hong Kong market has begun to pick up. The...

    Contact us to Open an Account

    Need Assistance? Share your Details and we’ll get back to you


    This material is provided by Phillip Capital Management (S) Ltd (“PCM”) for general information only and does not constitute a recommendation, an offer to sell, or a solicitation of any offer to invest in any of the exchange-traded fund (“ETF”) or the unit trust (“Products”) mentioned herein. It does not have any regard to your specific investment objectives, financial situation and any of your particular needs. You should read the Prospectus and the accompanying Product Highlights Sheet (“PHS”) for key features, key risks and other important information of the Products and obtain advice from a financial adviser (“FA“) pursuant to a separate engagement before making a commitment to invest in the Products. In the event that you choose not to obtain advice from a FA, you should assess whether the Products are suitable for you before proceeding to invest. A copy of the Prospectus and PHS are available from PCM, any of its Participating Dealers (“PDs“) for the ETF, or any of its authorised distributors for the unit trust managed by PCM.  

    An ETF is not like a typical unit trust as the units of the ETF (the “Units“) are to be listed and traded like any share on the Singapore Exchange Securities Trading Limited (“SGX-ST”). Listing on the SGX-ST does not guarantee a liquid market for the Units which may be traded at prices above or below its NAV or may be suspended or delisted. Investors may buy or sell the Units on SGX-ST when it is listed. Investors cannot create or redeem Units directly with PCM and have no rights to request PCM to redeem or purchase their Units. Creation and redemption of Units are through PDs if investors are clients of the PDs, who have no obligation to agree to create or redeem Units on behalf of any investor and may impose terms and conditions in connection with such creation or redemption orders. Please refer to the Prospectus of the ETF for more details.  

    Investments are subject to investment risks including the possible loss of the principal amount invested. The purchase of a unit in a fund is not the same as placing your money on deposit with a bank or deposit-taking company. There is no guarantee as to the amount of capital invested or return received. The value of the units and the income accruing to the units may fall or rise. Past performance is not necessarily indicative of the future or likely performance of the Products. There can be no assurance that investment objectives will be achieved.  

    Where applicable, fund(s) may invest in financial derivatives and/or participate in securities lending and repurchase transactions for the purpose of hedging and/or efficient portfolio management, subject to the relevant regulatory requirements. PCM reserves the discretion to determine if currency exposure should be hedged actively, passively or not at all, in the best interest of the Products.  

    The regular dividend distributions, out of either income and/or capital, are not guaranteed and subject to PCM’s discretion. Past payout yields and payments do not represent future payout yields and payments. Such dividend distributions will reduce the available capital for reinvestment and may result in an immediate decrease in the net asset value (“NAV”) of the Products. Please refer to <> for more information in relation to the dividend distributions.  

    The information provided herein may be obtained or compiled from public and/or third party sources that PCM has no reason to believe are unreliable. Any opinion or view herein is an expression of belief of the individual author or the indicated source (as applicable) only. PCM makes no representation or warranty that such information is accurate, complete, verified or should be relied upon as such. The information does not constitute, and should not be used as a substitute for tax, legal or investment advice.  

    The information herein are not for any person in any jurisdiction or country where such distribution or availability for use would contravene any applicable law or regulation or would subject PCM to any registration or licensing requirement in such jurisdiction or country. The Products is not offered to U.S. Persons. PhillipCapital Group of Companies, including PCM, their affiliates and/or their officers, directors and/or employees may own or have positions in the Products. Any member of the PhillipCapital Group of Companies may have acted upon or used the information, analyses and opinions herein before they have been published. 

    This advertisement has not been reviewed by the Monetary Authority of Singapore.  


    Phillip Capital Management (S) Ltd (Co. Reg. No. 199905233W)  
    250 North Bridge Road #06-00, Raffles City Tower ,Singapore 179101 
    Tel: (65) 6230 8133 Fax: (65) 65383066