Credit Spread
Also known as bond spread, bond credit spread, yield spread, credit risk
Credit spread is the difference between the yield (return) of two different debt instruments with the same maturity but different credit ratings. In other words, the spread is the difference in returns due to different credit qualities.
This indicates the credit spread relative to a benchmark rate
This provides a very simple way of comparing 2 bonds with the same maturity.
They are always measured in basis points (1% = 100 bp)
Using Government Bonds
Also known as G-Spread, government bond spread, nominal spread, treasury spread, traditional yield spread, nominal yield spread, yield to maturity spread, basic relative value
This credit spread is the difference between the yield to maturity of a non-treasury bond and its equivalent government bond with the same security.
In the US corporate bond market investors compare corporate bond yields to the yield of the closest "on-the-run" US treasury bond.
This approach has a few problems.
The first problem is that the maturity of the corporate bond might be different to the maturity of the treasury bond.
This makes it difficult to compare the credit spread of two companies in the same sector (ie relative-value analysis)
The second problem is that the coupons might be different (so duration and convexity would be different)
Lets assume that US Treasury notes currently have a yield of 3.39%
And the yield on a Microsoft bond is 4.27%
The credit spread of the Microsoft bond is (4.27 - 3.39) = 0.88% or 88 basis points
You can use the nominal spread as a way of pricing a bond.
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% (5% - 3%).
Credit Spread - Formula
Credit Spread = Corporate Bond Yield - Treasury Bond Yield
Credit Spread = (1 - Recovery Rate) (Default Probability)
The following factors will affect this credit spread
(1) Liquidity
(2) Taxes
(3) Accounting Transparency
(4) Defaulting history, if any
(5) Asset Liquidity
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