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The term “credit spread” refers to two distinct financial concepts: the difference in yield between Treasury and corporate bonds, which can serve as a market indicator, or an options strategy that capitalizes on premium differences.
As a market indicator, a credit spread uses these differing yields as an indicator of investor sentiment, and as a way to gauge how optimistic or risk-averse investors are feeling.
In options, a credit spread refers to a trading strategy in which an investor sells a higher-premium option while simultaneously purchasing a lower-premium option on the same underlying security.
Key Points
• Credit spreads reflect yield differences between Treasury and corporate bonds, which can indicate investor sentiment versus credit quality.
• Credit spreads can serve as a market risk indicator, with wider spreads suggesting higher perceived risk.
• Macroeconomic factors and market sentiment cause credit spreads to fluctuate.
• In options trading, a credit spread involves selling a higher-premium option and buying a lower-premium option.
• Strategies like bear call spreads and bull put spreads are types of credit spreads that try to benefit from option premium differences.
Credit Spread – the Market Indicator
A credit spread is the gap between the interest rate offered to investors by a U.S. Treasury bond versus another debt security with the same maturity. The differences in the yield of the different bonds– or credit spread – typically reflects differences in credit quality between Treasuries and other bonds.
Investors will also sometimes call credit spreads “bond spreads” or “default spreads.” For investors, credit spreads give investors a quick method for comparing a particular corporate bond versus its Treasury-based, lower-risk alternative.
When investors refer to credit spreads, they usually describe them in terms of basis points, each of which is a 1/100th of a percent (or a percent of a percent). For example, a 1% difference in yield between a Treasury bond and a debt security of the same duration would be called a credit spread of 100 basis points.
For example, if a 10-year Treasury note offers investors a yield of 3%, while a 10-year corporate bond offers to pay investors a 7% interest rate, there would be a 400 basis-point spread between them.
Recommended: What is Yield?
U.S. Treasury bonds are widely considered the benchmark of choice because the financial services industry views them as being relatively low-risk, given their backing by the U.S. government. By contrast, corporate bonds are generally seen as carrying higher risk even when they’re issued by well-established companies with good credit ratings.
Investors look for compensation in the form of extra yield when purchasing corporate bonds, given their additional risk. This is where a debt security’s credit spread comes in handy as an indicator of perceived risk.
Because they have a lower risk of defaulting, higher quality bonds can offer lower interest rates – and lower credit spreads – to investors. Conversely, lower quality bonds have a greater risk of default, and so they must offer higher rates – and higher credit spreads – to compensate investors for taking on additional risk.
Why Do Credit Spreads Fluctuate?
The credit spreads of corporate bonds may change over time for a number of reasons. This could be due to macroeconomic fluctuations such as inflation, or the degree of market enthusiasm for the company issuing the bond.
When equity markets appear to be heading for a downturn, both institutional and retail investors may sell stocks and corporate bonds, and then reinvest in U.S. Treasuries. This shift can lower the yields on U.S. Treasury bonds as investors seek safer assets, while corporate bond yields may rise in order to compensate for the perceived increase in risk. The result is often a widening of credit spreads.
This is one reason investors look at average credit spreads as a window into the overall market sentiment. Wider credit spreads indicate declining investor sentiment. Narrower credit spreads typically signify more bullish sentiment among investors.
What Is a Credit Spread in Options Trading?
In options trading, a credit spread takes on a new meaning. In an option credit spread strategy (also known as a “credit spread option” or a “credit risk option”), an investor buys and sells options on the same underlying security with the same expiration, but at different strike prices.
The hope is that the premium received for the option they sell is higher than the premium paid for the option they buy, resulting in a net credit for the investor.
The strategy takes two forms:
Bull Put Spread
In a bull put spread, an investor buys and sells options in which they’ll make a maximum return if the value of the underlying security goes up.
A bull put spread, also called a put credit spread, involves an investor selling a put option and purchasing a second put option with a lower strike price. The investor buys the same amount of both options with the same expiration date.
In a bull put spread strategy, as long as the price of the underlying security remains above a certain level, the strategy will begin to produce profits as the differences between the value of the two options begins to evaporate as a result of time decay. Time decay is how much the value of an options contract declines as that contract grows closer to its expiration date.
The maximum profit is limited to the net credit received, and losses are limited to the difference between the strike prices, minus the premium received.
As the name indicates, the bull put spread is a strategy used by investors who are bullish on a security. The higher the underlying security rises during the options contract, the better the investor will do. But if the underlying security falls below the long-put strike price, then the investor can lose money on the strategy.
Bear Call Spread
The other type of credit spread in options trading is known as a bear call spread (or a call credit spread). A bear call spread is essentially the opposite of a bull call spread: investors expect that a security’s price will go down. Thus, the investor buys and sells two options on the same security with the same expiration date, but at different strike prices.
A bull put spread can be a profitable strategy if the investor remains under a certain level over the duration of the options contracts. If the security is below the short call’s strike price at expiration, then the spread seller gets to keep the entire premium, giving the investor a healthy return. But the risk is that if the price of the security rises above the long-call strike price at the expiration of the strategy, then the investor faces a loss.
The Takeaway
A credit spread is an important indicator of investor sentiment. It’s also an options investing strategy where a high premium option is written and a low premium option is bought on the same security. Understanding the meaning of terms like credit spread is an important step for both new investors and experienced investors interested in options trading.
SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.
With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.
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