Credit Spreads Explained

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Credit Spread

What is a Credit Spread?

A credit spread is the difference in yield between a U.S. Treasury bond and another debt security of the same maturity but different credit quality. Credit spreads between U.S. Treasuries and other bond issuances are measured in basis points, with a 1% difference in yield equal to a spread of 100 basis points. As an example, a 10-year Treasury note with a yield of 5% and a 10-year corporate bond with a yield of 7% are said to have a credit spread of 200 basis points. Credit spreads are also referred to as “bond spreads” or “default spreads.” Credit spread allows a comparison between a corporate bond and a risk-free alternative.

A credit spread can also refer to an options strategy where a high premium option is written and a low premium option is bought on the same underlying security. This provides a credit to the account of the person making the two trades.

Credit Spread

Understanding Credit Spreads (bonds and options)

Credit Spread for Bonds

A bond credit spread reflects the difference in yield between a treasury and corporate bond of the same maturity. Debt issued by the United States Treasury is used as the benchmark in the financial industry due to its risk-free status being backed by the full faith and credit of the U.S. government. US Treasury (government-issued) bonds are considered to be the closest thing to a risk-free investment, as the probability of default is almost non-existent. Investors have the utmost confidence in getting repaid.

Corporate bonds, even for the most stable and highly-rated companies, are considered to be riskier investments for which the investor demands compensation. This compensation is the credit spread. To illustrate, if a 10-year Treasury note has a yield of 2.54% while a 10-year corporate bond has a yield of 4.60%, then the corporate bond offers a spread of 206 basis points over the Treasury note.

Credit Spread (bond) = (1 – Recovery Rate) * (Default Probability)

Credit spreads vary from one security to another based on the credit rating of the issuer of the bond. Higher quality bonds, which have less chance of the issuer defaulting, can offer lower interest rates. Lower quality bonds, with a higher chance of the issuer defaulting, need to offer higher rates to attract investors to the riskier investment. Credit spreads fluctuations are commonly due to changes in economic conditions (inflation), changes in liquidity, and demand for investment within particular markets.

For example, when faced with uncertain to worsening economic conditions investors tend to flee to the safety of U.S. Treasuries (buying) often at the expense of corporate bonds (selling). This dynamic causes US treasury prices to rise and yields to fall while corporate bond prices fall and yields rise. The widening is reflective of investor concern. This is why credit spreads are often a good barometer of economic health – widening (bad) and narrowing (good).

There are a number of 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 are larger for debt 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.

Key Takeaways

  • A credit spread reflects the difference in yield between a treasury and corporate bond of the same maturity.
  • Bond credit spreads are often a good barometer of economic health – widening (bad) and narrowing (good).
  • A credit spread can also refer to an options strategy where a high premium option is written and a low premium option is bought on the same underlying security.
  • A credit spread options strategy should result in a net credit, which is the maximum profit the trader can make.

Credit Spreads as an Options Strategy

A credit spread can also refer to a type of options strategy where the trader buys and sells options of same type and expiration but with different strike prices. The premiums received should be greater than the premiums paid resulting in a net credit for the trader. The net credit is the maximum profit that 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.

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An example of a bear call spread would be buying a January 50 call on ABC for $2, and writing a January 45 call on ABC for $5. The trader’s account nets $3 per share (with each contract representing 100 shares) as he receives the $5 premium for writing the January 45 call while paying $2 for buying the January 50 call. If the price of the underlying security is at or below $45 when the options expire then the trader has made a profit. This can also be called a “credit spread option” or a “credit risk option.”

Credit Spreads

A credit spread is an option spread strategy in which the premiums received from the short leg(s) of the spread is greater than the premiums paid for the long leg(s), resulting in funds being credited into the option trader’s account when the position is entered.

The net credit received is also the maximum profit attainable when implementing the credit spread option strategy.

Vertical Credit Spreads

Bull Credit Spread

The bull put spread is the option strategy to employ when the option trader is bullish on the underlying security and wish to establish a vertical spread on a net credit.

Bear Credit Spread

If instead, the option trader is bearish on the underlying security, a vertical spread can also be established on a net credit by implementing the bear call spread option strategy.

Non-directional Credit Spread Combinations

Spreads can be combined to create multi-legged, credit spread combinations that are employed by the option trader who does not know or does not care which way the price of the underlying security is headed but instead, is more interested in betting on the volatility (or lack thereof) of the underlying asset.

Bullish on Volatility

If the option trader expects the price of the underlying security to swing wildly in the near future, he can choose to implement one of the following spread combination strategies on a net credit.

Bearish on Volatility

If instead, the option trader expects the price of the underlying security to remain steady in the near term, he can choose to implement one of the following credit spread combination strategies.

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Credit spreads explained

Anyone who goes on an introductory course in options trading will no doubt become familiar
with credit spreads. This remains one of the most popular trading strategies among traders of
all levels for a variety of reasons.

Definition

A credit spread is an options trading spread for which the trader does not have to pay an
upfront fee. Instead the trader is actually paid to set up a credit spread! The reason for this is
that credit spreads involve selling more expensive options and buying cheaper ones, which
means the net premium results in a credit to the trader’s account.

Margin and trading Level

There is a trade-off though: whereas a debit spread does not involve any margin, since
the trade can usually not lose more than the net cost to set up the position, a credit spread
sometimes has the potential to lose an unlimited amount of money. This results in brokers
requiring a margin deposit before a trader can set up a debit spread. For stock options a
higher trading level is usually also required than for debit spreads.

Benefits of credit spreads

Whereas most debit spreads require the price of the underlying asset to move either up
or down in order to profit, credit spreads have the unique ability to profit if the price of the
underlying asset remains stagnant or moves in a narrow range.

Although some credit spreads have unlimited potential for loss, there are also many other
credit spreads with a limited potential for loss.

While credit spreads require a margin deposit, they still require a smaller margin deposit than
naked puts or naked calls. In fact the lower margin involved is one of the reasons why many
traders prefer credit spreads over selling naked options.

Although most credit spreads will profit in a stagnant or range-trading market, there are also
credit spreads that will profit if the market breaks out either to the upside or the downside.

A credit spread for bullish markets

Below is an example of a typical bullish credit spread, the bull put spread. This involves
selling ATM put options and simultaneously buying OTM put options for the same expiration
date.

A credit spread for bearish markets

Below is an example of a credit spread for a bearish market. The bear call is set up by selling
ATM call options and simultaneously buying the same number of OTM call options for the
same expiration date.

A credit spread for neutral markets

If a trader believes the market will remain either stagnant or range-bound until the expiration
date he or she can’t do much better than a credit spread specifically intended for neutral
markets. One such example is the very popular iron condor, which consists of selling OTM
calls and OTM puts while simultaneously buying further OTM calls and puts which are
cheaper.

Fig. 9.28(d) is an example of a typical iron condor credit spread.

A credit spread for volatile markets

If it is highly likely that the price of the underlying asset will break out either to the upside or
the downside, a trader should opt for a credit spread designed specifically to benefit from this
situation. An example in this regard is the ever popular short butterfly spread that is illustrated
below in Fig. 9.28(e).

This trade is set up by buying two ATM call options and simultaneously selling an OTM call
and an ITM call. The higher premium income from the ITM call helps to more than offset the
cost of the ATM calls, creating a net credit.

Conclusion

While credit spreads can be ideal under certain circumstances, one always has to take into
account a) the probability of the trade actually realising a profit and b) whether the maximum
risk/maximum profit payoff justifies the trade.

About the Author

Marcus Holland – Marcus Holland has been trading the financial markets since 2007 with a particular focus on soft commodities. He graduated in 2004 from the University of Plymouth with a BA (Hons) in Business and Finance.

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