The term “credit spread” refers to two separate financial terms.
A credit spread is an important indicator of investor sentiment that compares the yields offered by Treasuries and corporate bonds as a way of understanding how optimistic or risk-averse investors are feeling.
But credit spread also refers to an options-trading strategy where an investor sells a high-premium option and simultaneously purchases a low-premium option on the same underlying security.
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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 shorthand for comparing a particular corporate bond versus its risk-free alternative.
When investors refer to credit spreads, they usually describe them in terms of basis points, each of which is 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.
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The bonds issued by the U.S. Treasury are the benchmark of choice because the financial-services industry considers them relatively risk-free, given their backing by the U.S. government. Investors consider corporate bonds, on the other hand, riskier, even when they’re issued by the largest, longest-tenured and most highly rated companies in the most stable industries.
To purchase debt securities with that added risk, investors look for compensation in the form of extra yield. That’s why investors sometimes look at a debt security’s credit spread as an indicator of the perceived riskiness of a company’s bonds or the creditworthiness of the company itself.
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 default, and so they must offer higher rates – and higher credit spreads – to compensate investors for taking on that risk.
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Why Do Credit Spreads Fluctuate?
The credit spreads of the bonds issued by a given company may change over time for a number of reasons. They may change because of macroeconomic fluctuations such as inflation, or the degree of market enthusiasm for the company issuing the bond.
When the equity markets seem headed for a downturn, both institutional and retail investors often sell stocks and corporate bonds, and then reinvest in U.S. Treasuries. That pushes down the yields offered by U.S. Treasury bonds as investors flee to safety, while the yields paid by corporate bonds rise in order to entice skittish investors. The result is a general widening of credit spreads across the board.
That dynamic is one reason that investors look at average credit spreads as a window into the overall market sentiment, in which wider credit spreads indicate declining investor sentiment. Narrower credit spreads typically signify more bullish sentiment among investors. That’s because during a bull market the safety of Treasuries holds less appeal to investors, forcing the notes to offer higher rates. Meanwhile, that same confidence leads investors to see corporate debt as less risky, allowing companies to issue bonds with lower yields.
What Is a Credit Spread in Option Trading?
Sometimes, investors use the term “credit spread” to refer not just to the difference in yield offered by a Treasury bond and a similar security, but also as a specific options trading strategy. The strategy is also sometimes known as a “credit spread option” or a “credit risk option.”
In an option credit spread strategy, an investor buys and sells options on the same underlying security with the same expiration, but at different strike prices. The premiums the investor receives on the option they sell should be higher than the premiums they pay on the option they buy, which leads to a net return for the investor.
The strategy takes two forms:
Bull Put Spread
In the bull put spread, in which the 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 is often also called a put credit spread. In it, an investor sells a put option and purchases a second put option with a lower strike price. For the strategy to work, the investor buys the same amount of both options and, both options will have 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.
As the name indicates, the bull put spread is a strategy used by investors who are bullish on a security. And 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 credit-spread is called the bear call spread, or a call-credit spread. That strategy is, in many ways, the mirror opposite of the bull put spread. Investors in this strategy expect that a security’s price will go down. In it, the investor buys and sells two options on the same security, with the same expiration date but at prices where the investor will receive the maximum return if the price of the underlying security sinks.
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.
Recommended: A Guide to Options Trading
The Takeaway
A credit spread is an important indicator of investor sentiment. It’s also an options 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 new investors who are just starting to invest in stocks.
The SoFi options trading platform is a great way to get started, thanks to its user-friendly design. Investors can trade from the mobile app or web platform. And should any questions come up along the way, there’s a library of educational resources about options available.
Photo credit: iStock/Astarot
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