A corporate bond yields 6%. Is that high, low, or attractive? By itself, the number tells you surprisingly little.
Bond investors therefore compare that yield with a benchmark, commonly a Treasury of similar maturity. The difference between the two yields is the credit spread, and it gives investors a more useful starting point for evaluating the extra yield offered by corporate debt.
Start With the Benchmark
Suppose a similar-maturity Treasury yields 4% and the corporate bond yields 6%.
The difference is 2 percentage points. Bond markets usually express that difference in basis points. One basis point equals 0.01 percentage point, so:
6.0% – 4.0% = 2.0 percentage points = 200 basis points
The corporate bond therefore trades at a spread of about 200 basis points, or 200 bps, over the Treasury benchmark.
Treasuries are commonly used as benchmarks because they carry extremely low credit risk and trade in a deep, liquid market. The maturity match matters too: Treasury yields differ across maturities, so a corporate bond should be compared with a broadly similar point on the Treasury curve.
In this simple comparison:
Corporate bond yield = benchmark Treasury yield + credit spread
What a Credit Spread Reflects
Default risk is the obvious starting point. If investors judge a company more likely to miss interest or principal payments, they will generally require a wider spread.
But expected credit loss depends on more than the chance of default. Investors also care about recovery, or how much value they might receive if a default occurs. A bond expected to recover most of its value is different from one where losses could be severe.
A 200-basis-point spread should therefore not be read as a 2% probability of default.
Liquidity can matter too. Corporate bonds are often less liquid than Treasuries, so investors may demand extra yield for the risk that selling quickly could mean accepting a worse price.
Broader market conditions also affect spreads. During economic or financial stress, investors may require a larger risk premium for holding corporate debt even before a particular issuer’s fundamentals deteriorate.
So a credit spread is not a pure default forecast. It can reflect expected credit losses, liquidity, and the broader risk premium investors demand for holding corporate debt.
Why Credit Spreads Widen and Narrow
Credit spreads change as investors reassess the extra yield they require on corporate debt relative to the benchmark.
Using the earlier example, suppose the Treasury yield stays at 4%, but concerns about the company increase. If investors now require the corporate bond to yield 7%, its spread widens from 200 to 300 basis points.
The reverse can happen when conditions improve. If investors require less extra yield to hold the corporate bond, the spread narrows, or tightens.
The Treasury side can move too. If the corporate yield stays unchanged while the Treasury yield falls, the spread widens. If the Treasury yield rises faster than the corporate yield, the spread narrows.
Read Credit Spreads in Context
A wider spread is not automatically more attractive. It offers more extra yield, but that extra yield may simply be compensation for greater risk. The more useful question is how the spread compares with similar bonds and what is changing around it.
If one company’s spread widens while similar issuers remain relatively stable, the concern is more likely to be company-specific, perhaps weaker earnings, rising leverage, or refinancing pressure.
If spreads widen across an industry, the problem may be broader. Energy producers, for example, can reprice together when oil prices fall sharply, while banks may move together when concerns about funding or credit losses rise.
If spreads widen across much of the corporate bond market, the move is more likely to reflect a market-wide shift than a problem unique to one issuer.