Economic Health and Credit Spreads

Credit spread, also known as “the spread”, is the difference in yield “return” between two debt instruments with the same maturity but different credit ratings. The different credit ratings reflect the additional risk that investors take on when lending a borrower that might be not as credit worthy compared to a risk-free benchmark rate, usually a U.S. Treasury Bond with the same maturity period.

For example, if a 5-year Treasury note is trading at a yield of 3% and a 5-year corporate bond is trading at a yield of 5%, the credit spread is 2%. Credit spreads indicate how the market perceives the creditworthiness of corporate borrowers. A higher credit spread often indicates an unhealthy economy, as this suggests that the market sees the borrower as having a higher risk of defaulting on their debt.

Credit spreads are not static, they change over time. This change is usually caused by the economic climate and conditions. When the economy deteriorates, investors tend to purchase U.S. Treasuries and sell their holdings in corporate bonds. Capital inflows to U.S. Treasuries would increase the price of the treasuries and decrease their yield. On the contrary, when the economy improves, capital outflows from U.S. Treasuries would decrease the price and increase the yield on the treasuries. In such a scenario, credit spreads between U.S. Treasuries and corporate bonds would become more narrow. Many investors recognize that credit spreads are among one of the best indicators of broader economic health. In bond trading, the credit spread can have an impact on the investment returns of investors.

An example of the credit spread widening while the economy deteriorated was during the Great Financial Crisis, otherwise known as 2008 Global Financial Crisis. According to Kozlowski, J., Faria-e-Castro, M. and Jordan-Wood, S. (2021), the cost of borrowing increased credit spreads by nearly 300 basis points early in the crisis. Debt, however, trended consistently downward for all four quarters after the start of the crisis, ending with nonfinancial corporations having about 4% less debt in the third quarter of 2009 than in the third quarter of 2008. Liquid asset holdings sharply declined in the first quarter after the start of the GFC, falling 34%. During the following two quarters, liquid assets slowly trended upward but remained 24% to 28% below the level in the third quarter of 2008.

All in all, credit spread is used universally by many investors to look into the health of the economy. This article aims to alleviate the understanding and usage of credit spreads in everyday investing. By understanding how to interpret these spreads, investors can gain valuable insights into the economy and make more informed investment decisions. 

Written by:

Lee Yuan Jun

1st Year Student at Taylor's University,

Bachelor of Business (Honours) in Finance and Economics

References: 

Stonex.com. (2024). Credit spreads. [online] Available at: https://www.stonex.com/en/financial-glossary/credit-spreads/  [Accessed 23 Dec. 2024]. 

Corporate Finance Institute. (n.d.). Credit Spread. [online] Available at: https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/credit-spread/ [Accessed 23 Dec. 2024].

Ganti, A. (2019). Credit Spread Definition. [online] Investopedia. Available at: https://www.investopedia.com/terms/c/creditspread.asp [Accessed 23 Dec. 2024]. 

Kozlowski, J., Faria-e-Castro, M. and Jordan-Wood, S. (2021). The Comovement between Credit Spreads, Corporate Debt and Liquid Assets in Recent Crises. [online] Stlouisfed.org. Available at: https://www.stlouisfed.org/on-the-economy/2021/november/comovement-credit-spreads-debt-assets-crises?utm_source=chatgpt.com [Accessed 23 Dec. 2024].