eFinancialCareers

What is it?

An indigestible sandwich filler. The term credit spread refers to the difference between the amount of money an investor in a risky bond can expect to receive in regular payments and the returns paid out on a bond which is considered a much less risky investment.

First of all, the risky bond – let’s say it costs the buyer $100 and has to be repaid after three years. But the company that issued the bond isn’t very financially sound and there’s a risk it may never pay the bond off when the three years are up. As a result, that company pays the holder of the bond $15 a year just to keep them happy.

By comparison, a bond which costs $100 but was issued by the US Treasury (and which, until recently, was not considered to be risky at all) might pay only $5 a year to its owner.

Credit spreads are usually explained in basis points, or 100ths of a percentage point. In the example above, the spread is therefore huge – while the yield on one bond is 15%, the yield on the other is only 5%. The spread between the two is therefore 10%, and would be referred to as a spread of 1,000bp (basis points).

What’s it got to do with the financial crisis?

In the years preceding the credit crunch, credit spreads narrowed hugely – ie, the difference between the payouts on a risky bond and the payouts on non-risky bond fell.

The long-term average credit spread between very risky so-called ‘junk’ bonds and American treasuries is 500 basis points, according to the Return to A-Z home page