Credit spread

A credit spread is the extra yield a bond offers above a comparable Treasury bond of the same maturity, compensating an investor for taking on credit risk that a Treasury does not carry.

The formula is:

If a ten year corporate bond yields six percent while the ten year Treasury yield sits at four percent, the credit spread is two percentage points, often expressed in basis points as two hundred.

Credit spreads widen when investors grow more worried about defaults, whether because of a specific company's deteriorating finances or a broader shift in economic conditions, and they narrow when confidence improves. Since spreads reflect the market's collective judgment about default risk in something close to real time, a rapid widening in credit spreads across the bond market is often watched as an early signal of economic stress, sometimes appearing before the effects show up in stock prices.

Different categories of bonds trade at different typical spread levels. Investment-grade bonds trade at relatively tight spreads over Treasuries, while high-yield bonds trade at much wider spreads to compensate for their materially higher chance of default. A bond downgraded from investment grade to high-yield status, known as a fallen angel, typically sees its credit spread widen sharply as it moves between these two categories, even if nothing about its actual cash flows has changed yet.