savvy investors know that credit spreads may be one of the best indicators of the broader economy s health not just the creditworthiness of this or that company in bond trading the difference between the yields of two bonds with the same maturity but different credit quality is known as the credit spread and it can have a significant effect on your investment returns 
credit spreads are measured in basis points which are equal to 0 01 for example a 1 difference in yield is equal to a spread of 100 basis points also known as bond yield or default spreads they allow you to quickly compare the yields of corporate bonds to risk free alternatives such as treasury notes for instance if a 10 year treasury note yields 5 and a 10 year corporate bond yields 7 the credit spread between the two bonds is 200 basis points analysts also aggregate all corporate bonds of a particular type subtract out the treasury rates and assess the expectations for the broader economic climate wider yields portend a dire outlook while narrowing yields indicate economic optimism it s important to note that credit spreads also refer to an options trading strategy in that context a credit spread concerns writing a high premium option and buying a low premium option on the same underlying asset which results in a credit to the account of the person making the two trades below we take you through how to calculate credit spreads and why they re essential when investing investopedia jake shibond credit spreadsa bond credit spread also known as a yield spread is the difference in yield between two bonds with similar maturities but different credit qualities it is a measure of the additional yield that investors demand for holding a bond with a higher perceived credit risk than a safer bond such as a government bond or a high quality aaa rated corporate bond over a junk bond 1the bond credit spread is typically given in basis points bps where 1 bp equals 0 01 for instance if bond a has a yield of 5 and bond b has a yield of 4 the credit spread between them is 100 bps or 1 bond credit spreads are often used to gauge the market s perception of the creditworthiness of a particular issuer or sector a wider credit spread means that investors perceive a higher risk of default and require a higher yield to compensate for that risk conversely a narrower credit spread suggests that investors are more confident in the issuer s ability to meet its debt obligations and are willing to accept a lower yield here are a few examples of bond credit spreads investors analysts and policymakers closely monitor bond credit spreads since they provide valuable insights into market sentiment risk perception and the overall health of the bond market changes in credit spreads also have implications for borrowing costs investment strategies and economic growth interpreting bond yield spreads for economic healththe yield spread between corporate bonds and 10 year treasury bonds has long been seen as a crucial indicator of economic conditions and investor sentiment yield spreads reflect the additional compensation investors require for taking on the risk of corporate bonds over the relatively risk free treasurys in typical economic conditions the spread between high quality corporate bonds such as those rated aaa and 10 year treasurys typically ranges from 1 to 2 for lower quality corporate bonds such as bbb rated bonds the spread is usually higher ranging from 2 to 4 or more these spreads provide greater insight into investor sentiment about the economy than many other economic indicators interpreting yield spreadsa narrow yield spread close to 1 suggests that investors are confident in the economic outlook and believe that the risk of corporate defaults is low this is often seen during strong economic conditions where investors are willing to accept lower premiums for holding corporate debt meanwhile a widening yield spread indicates increased concern about the economy as investors become more risk averse they demand higher yields on corporate bonds to compensate for the perceived higher risks of default the worse the economy the more corporations are likely to default on their borrowing as you can see from the chart below widening spreads signal economic uncertainty a potential downturn or a grave and vast crisis as with the bond yield spread spikes after the events of sept 11 2001 the 2007 to 2008 financial crisis and the pandemic when economic jitters if not panic were felt in the bond markets and beyond yield spreads moving closer to and below 1 0 show greater confidence in the broad economy the credit spread of a bond is a measure of the additional yield that investors demand for holding a bond that s a higher credit risk it can be approximated using the formula in this formula the recovery rate represents the percentage of the investment that investors expect to recover in the event of a default while the default probability represents the likelihood of the issuer not paying its debt obligations the term 1 recovery rate represents the expected loss given default which is then multiplied by the probability of default to estimate the overall expected loss for the bond the expected loss serves as a proxy for the credit spread as investors would require a higher yield to compensate for the potential loss however this formula is a simplification and doesn t account for all the factors that influence credit spreads such as liquidity risk market sentiment and the specific cash flow characteristics of the bond credit spreads are larger for riskier debts such as those issued by emerging markets and lower rated corporations than by government agencies and wealthier and or stable nations spreads are larger for bonds with longer maturities calculating a credit spread between bonds and treasurysa credit spread is often used to report the difference in yield between a treasury and corporate bond of the same maturity this is because bonds issued by the u s government are considered risk free the spread thus reflects the added compensation investors require for assuming the higher default risk of corporate bonds compared with risk free government bonds the formula for calculating credit spread between bonds is as follows let s say we want to calculate the credit spread for a 10 year corporate bond issued by abc corporation the bond yields 5 and the yield on a 10 year treasury is 3 subtract the treasury bond yield from the corporate bond yield in this example the credit spread is 2 or 200 basis points as such investors require 2 additional percentage points in yield to hold abc corporation s bonds over holding risk free 10 year treasury bonds a higher credit spread means that the market perceives the corporate bond as having a higher risk of default a lower credit spread suggests that the corporate bond is considered safer there are bond market indexes that investors and financial experts use to track the yields and credit spreads of different types of debt with 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 in options tradinga credit spread can also refer to a type of options strategy where the trader buys and sells options of the same type and expiration but with different strike prices in this context bond yields are not involved in a credit spread involving options the premiums received should be greater than the premiums paid resulting in a credit for the trader the net credit is the maximum profit a trader can make two such strategies are the bull put spread where the trader expects the underlying security to go up and the bear call spread where the trader expects the underlying security to go down an example of a credit spread that could be a bear call spread would include buying a january 50 call on abc for 2 and writing a january 45 call on abc for 5 let s break this down your profit or loss depends on the price of abc stock at expiration this strategy is called a credit spread because the trader receives a net credit for entering the position 