Credit Spread Definition – Explanation of How a Credit Spread Works

Credit Spread for Bonds

A bond credit spread reflects the difference in yield between a treasury and corporate bond of the same maturity. Debt issued by the United States Treasury is used as the benchmark in the financial industry.  This is due to its risk-free status being backed by the full faith and credit of the U.S. government. US Treasury,  government-issued bonds are considered to be the closest thing to a risk-free investment.  This is because the probability of default is almost non-existent. Investors have the utmost confidence in getting repaid.

Corporate bonds are considered to be riskier investments.  An investor demands compensation – even for the most stable and highly-rated companies. This extra compensation is realized through the credit spread. To illustrate, say a 10-year Treasury note has a yield of 2.50% while a 10-year corporate bond has a yield of 4.60%.  Then the corporate bond offers a spread of 210 basis points over the Treasury note.

Calculation

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

The spreads vary from one security to another based on the credit rating of the issuer of the bond. Higher-quality bonds have less chance of the issuer defaulting.  Therefore, they can offer lower interest rates. Lower-quality bonds, with a higher chance of the issuer defaulting, need to offer higher rates to attract investors to the riskier investment. Credit spread fluctuations are commonly due to changes in economic conditions (inflation), changes in liquidity, and demand for investment within particular markets.

For example, when faced with uncertain to worsening economic conditions investors tend to flee to the safety of U.S. Treasuries and buy.  This is often at the expense of corporate bonds that are sold. This dynamic causes US treasury prices to rise and yields to fall.  At the same time, corporate bond prices fall and yields rise. The widening spread is reflective of investor concern. This is why credit spreads are often a good barometer of economic health.  A widening spread is bad, and a narrowing spread is good.

There are a number of bond market indexes.  Investors and financial experts use these to track the yields and credit spreads of different types of debt.  Traders can follow maturities ranging from three months to 30 years. Some of the most important indexes include High Yield and Investment Grade U.S. Corporate Debt, mortgage-backed securities, tax-exempt municipal bonds, and government bonds.  Credit spreads are larger for debt issued by emerging markets and lower-rated corporations.  They are higher for government agencies and wealthier and/or stable nations. Also, spreads are larger for bonds with longer maturities.

Example

For example, assume the 10-year Treasury note is trading at a yield of 4% and a 10-year corporate bond is trading at a yield of 8%.  The corporate bond is said to offer a 400-basis-point spread over the Treasury. Widening credit spreads indicate growing concern about the ability of corporate (and other private) borrowers to service their debt. Narrowing credit spreads indicate improving private creditworthiness. ts

Credit Spread as an Options Strategy

A credit spread can also refer to a type of options strategy.  This is where the trader buys and sells options of the same type and expiration but with different strike prices. The premiums received should be greater than the premiums paid resulting in a net credit for the trader. The net credit is the maximum profit that the trader can make. One options trading strategy is the bull put spread, where the trader expects the underlying security to go up.  Another is the bear call spread, where the trader expects the underlying security to go down.

Bear Call Credit Spread Example

An example of a bear call spread would be buying a January 60 call on X Co for $2, and writing a January 55 call on X Co for $5. The trader’s account nets $3 per share.  Typically, each contract represents 100 shares.  He receives the $5 premium for writing the January 55 call while paying $2 for buying the January 60 call. If the price of the underlying security is at or below $55 when the options expire then the trader has made a profit. This can also be called a “credit spread option” or a “credit risk option.”

A credit spread option is an options contract that includes the purchase of one option and the sale of a second similar option with a different strike price. Effectively, by exchanging two options of the same class and expiration, this strategy transfers credit risk from one party to another. In this scenario, there is a risk that the particular credit will increase, causing the spread to widen, which then reduces the price of the credit. Spreads and prices move in opposite directions. An initial premium is paid by the buyer in exchange for potential cash flows if a given credit spread changes from its current level. (Source: ibid)

Credit put spread

A credit put spread can be used in place of an outright sale of uncovered put options.  The sale of an uncovered put option is a bullish trade.  It can be used when you expect the underlying security or index to move upward. The goal is usually to generate income when the uncovered put option is sold.  Then, to wait until the option expires worthless. Although the downside risk of uncovered puts is not quite unlimited, it is substantial.  This is because you could lose money until the stock drops all the way to zero.

Credit spreads involve the simultaneous purchase and sale of options contracts of the same class (puts or calls) on the same underlying security. In the case of a vertical credit put spread, the expiration month is the same, but the strike price will be different.  When you establish a bullish position using a credit put spread, the premium you pay for the option purchased is lower than the premium you receive from the option sold. As a result, you still generate income when the position is established, but less than you would with an uncovered position.

Credit call spread

A credit call spread can be used in place of an outright sale of uncovered call options.  The sale of an uncovered call option is a bearish trade.  It can be used when you expect the underlying security or index to move downward. The goal is usually to generate income when the uncovered call option is sold.  Then, wait until the option expires worthless. When you establish a bearish position using a credit call spread, the premium you pay for the option purchased is lower than the premium you receive from the option sold. As a result, you still generate income when the position is established, but less than you would with an uncovered position.

The mechanics of a credit call spread (a type of vertical spread) are virtually the same as those of a credit put spread.  Except, the profit and loss regions are on opposite sides of the break-even point. 

Credit Spread – Advantages and Disadvantages

To summarize, credit put and credit call spreads have both advantages and disadvantages compared to selling uncovered options.

Credit Spread Advantages

• Spreads can lower your risk substantially if the stock moves dramatically against you.
• The margin requirement for credit spreads is substantially lower than for uncovered options.
• It is not possible to lose more money than the margin requirement held in your account at the time the position is established. With uncovered options, you can lose substantially more than the initial margin requirement.
• Debit and credit spreads may require less monitoring than some other types of strategies because once established, they’re usually held until expiration. However, spreads should be reviewed occasionally to determine if holding them until expiration is still warranted—for example, if the underlying instrument moves far enough and quickly enough, you may be able to close out the spread position at a net profit prior to expiration.
• Spreads are versatile. Due to the wide range of strike prices and expirations that are typically available, most traders are able to find a combination of contracts that will allow them to take a bullish or bearish position on a stock. This is true of both debit spreads and credit spreads.

 Credit Spread Disadvantages

• Your profit potential will be reduced by the amount spent on the long option leg of the spread.
• Because a spread requires two options, the commission costs to establish and/or close out a credit spread will be higher than the commissions for a single uncovered position.

(Source: schwab.com)

Up Next: Day Trading For Beginners – What Is A Day Trader?

Day trading can be summarized simply as buying a security and quickly selling or closing out the position within a single trading day.  Ideally, a day trader wants to “cash-out” by the end of each day with no open positions to avoid the risk of losses by holding a security overnight.  Day trading is not for everyone and carries significant risks. It requires an in-depth understanding of how the markets work and various strategies for profiting in the short term.  Short term profits require a very different approach compared to traditional long term, buy and hold investment strategies.