Credit spreads: A fixed income investor's must-know guide (Part 1 of 6)
Credit spreads are the difference in yield between U.S. Treasuries and corporate bonds of the same maturity. Corporate bonds yield more than Treasury bonds, as they carry a risk of default. The difference in yields between a corporate bond and a Treasury of the same maturity is actually the premium that investors require for undertaking the additional credit risk associated with the corporate bond.
U.S. Treasury bonds are considered the safest, as they’re issued and guaranteed by the government of United States.
Calculating credit spreads
The credit spread between a ten-year corporate bond yielding 5% and the ten-year Treasury bond yielding 2% would be 3%.
The current bond yield for a five-year Exxon Mobil (XOM) bond is 1.82%. The corresponding five-year Treasury bond yield stands at 1.73%. So the credit spread for the Exxon Mobil bond would be 0.09%, or 9 basis points.
At the same time, a five-year JP Morgan Chase (JPM) bond yields 6.3%. Here, the credit spread is much wider, at 4.57% or 457 basis points, than Exxon Mobil’s, where the spread is tighter or narrower. This shows that the JPM bond carries more credit risk than the XOM bond.
Credit spreads for a category of bonds
In addition to looking at credit spreads for individual bonds, investors may also want to look at the credit spread of different categories of bonds. For example, by comparing a group of corporate bonds (like high-yield bonds) versus Treasuries, you can get a picture of where the average high-yield bond credit spread currently stands.
There are various indices available that enable this comparison. The iShares iBoxx $ High Yield Corporate Bond ETF (HYG), which tracks the iBoxx $ Liquid High Yield Index, and the SPDR Barclays Capital High Yield Bond ETF (JNK), which tracks the Barclays Capital High Yield Very Liquid Index, are popular ETFs tracking indices in the high-yield bonds category.
Similarly, in the leveraged loans category, the S&P/LSTA U.S. Leveraged Loan 100 Index (SPBDLL) is a popular measure that tracks the market-weighted performance of the largest institutional leveraged loans. The PowerShares Senior Loan Portfolio Fund (BKLN), with companies like H.J. Heinz Company (HNZ) and Fortescue Metals Group (FMG) in its portfolio, tracks this index.
To find out more about the relationship between interest rates and credit spreads, read on to the next part of this series.
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