Understanding Credit Spreads

One important indicator of the state of the economy is the credit spread. Before we start explaining how the credit spread can give you valuable insight into the economy, you first have to understand what a credit spread is. To understand those, you need to know the basics of Treasury Securities and Corporate Bonds.

A general credit spread is a comparison between the yields of two bonds with equal maturity, but different credit ratings. The difference is measured in "basis points." Every 0.01% difference between the two bonds is 1 basis point. Therefore, if bond A has a 6% yield and bond B has a 7% yield, the credit spread would be 100 basis points. Remember that yield increases as risk of default increases; so the credit spread is showing the increase in yield you can expect with an increase in risk. Typically when you are calculating credit spread, you will be comparing a bond to a treasury security. This is because treasury securities are the safest investment as they are backed by the United States Government - essentially risk free. This makes treasury securities a good benchmark to compare the relative risks of other bonds against.

However, when we are trying to use credit spreads to look at the economy as a whole, we are not going to compare 2 random bonds. While knowing the risk of investing in company A compared to a treasury security is useful when analyzing that specific company, it is not going to be an accurate reflection of the economy as a whole. This is why large groups of corporate bonds are measured at once. There are many different indexes that are composed of various corporate bonds.  A list of some of the major indexes can be found at the Wall Street Journal.

Why are credit spreads important when looking at the economy? First, let's think about what the credit spread is measuring. It is showing the return people expect for the risk they are taking by investing their money in a company. If people think they are taking a high risk by investing, they will expect a high yield to compensate. Since it is always compared with treasury securities, which are risk free, rising risk/yields will mean a widening credit spread. If they feel safe investing, they will not expect as high of a return because they are not taking as much of a risk. This would make the yields/risks closer to that of treasury securities and the credit spread will narrow. 

Now, if the credit spread for a single company widens, that is a sign people think that investing in that particular company is risky; they believe it is more likely that company will default on its loans for whatever reason. While this is not good for the company, it doesn't say much about the economy. However, if the credit spread for a huge index widens, this means people are afraid to invest AT ALL. They think that all companies have a higher risk of defaulting. There is wide concern of the ability of all companies to deal with their debts. It is not only predictive of how people think these companies will do in the future; it actually hurts the companies as well. One of the ways companies raise money is by selling bonds. If less people are buying, as well as demanding higher yields, this makes it more likely that companies will default on their loans because they won't be able to raise enough capital.

Here are two graphs of credit spreads over the past 10 years. Both are compared to a 20 year Treasury Constant Rate. The first graph shows the spread with Moody's Seasoned Aaa corporate bond yield; a collection of corporate bonds with aaa ratings - their highest. The second shows Moody's Seasoned Baa corporate bond yield. Baa is considered "lower medium grade," much more risky.


Data is from: http://research.stlouisfed.org/
You can see the recent high spikes in both, though it is much more drastic in the Baa bonds. This shows that the credit spread is widening right now, a sign that people do not have faith in companies' abilities to pay off their bonds, especially those that do not have great credit ratings to begin with.

So what does this say about our economy right now? It shows that people are uncertain about the future of the economy, they are unsure when the current crisis will end. Overall when companies are at risk of defaulting, that means that they are not generating enough income. Usually this is because consumers are not spending enough money, showing that the economy is in bad shape. S&P has said that 35 companies have defaulted so far this year, compared to 12 in the same period last year. Big name companies such as Blockbuster are cited as risks for defaulting. Certain companies such as GE have had their credit rating downgraded. All of these factors contribute to people seeing these investments as riskier.

This basic understanding of credit spreads can really help you understand what directions companies and the economy are moving in.