Let’s check the credit spread calculator. With this tool, you will be able to quickly estimate the credit spread for different corporate bonds. So be sure to use it before making an investment decision. Why is it important?
Credit spread is a vital metric that plays a role in assessing credit quality and related bonds. This makes it important for every company, no matter what type of business is in question.
In this article, you can find out more about a credit spread and how to calculate it using our calculator or the appropriate formula. We will also provide some real-life examples to help you get a better understanding of credit spread strategies work. Without further ado, let’s dig into it!
Credit Spread: What Is It?
A credit spread is a difference between the price at which a trader can buy and sell a given security. We think of the difference in the price of two different securities that are both available to be bought or sold. The trader will buy one option and sell another option with a higher strike price. A credit spread is a type of options strategy that is designed to profit from the difference in implied volatility between two different credit instruments.
Likewise, the credit spread can be defined as the difference between the yield on a bond and the yield on a comparable Treasury bond. It refers to the difference between the yields on two securities of comparable quality and duration.
For example, if Company XYZ has an 8% coupon rate but its bonds are yielding 6%, it would have a 2% credit spread over Treasuries. It is typically quoted as a percentage of the lower-yielding security. For instance, if one security has a yield of 3% and another has a yield of 5%, the spread will be 2%. Credit spreads are also known as credit risk premiums.
The most common type of credit spread is the “normal” or “positive” credit spread, which occurs when long-term rates are higher than short-term rates. This means that investors will receive more return on their investment in the long term, but they will have to wait longer for their money to grow. A negative credit spread occurs when short-term rates are higher than long-term rates, meaning that investors can get their money back sooner, but they will have less return on their investment in the long term.
Credit Spread Formula: How Is It Calculated?
For the credit spread calculation, you will need the following inputs:
- Government bond yield
- Corporate bond yield
- Maturity (expressed in number of years) of the corporate bond, and
- Maturity (expressed in years) of the government bond.
Now you can calculate the credit spread. It involves three steps.
Step 1: Determining the yield to maturity (YTM) of a corporate bond
You can find this info on financial sites like Yahoo Finance, Vanguard, and Fidelity. As an alternative, this information can be obtained by looking over annual reports of the companies. It’s likely that your company has recorded the information on bond issuance.
Step 2: Determining YTM of a government bond
This information is usually easy to access. For example, you can get it by performing an online search or visiting the website of the relevant government, such as the Federal Reserve Board site. When comparing the corporate and government bonds, make sure that you use the same maturity.
Step 3: Calculating the credit spread
Once you have determined the YTM of corporate and government bonds, you can compute the credit spread. It is easy to calculate. Use this simple formula:
Credit Spread = Corporate Bond Yield – Government Bond Yield
Example
- Corporate Bond Yield: 5.10%
- Government Bond Yield: 1.70%
In this example, the credit spread is as follows:
Credit Spread = 5.10% – 1.70% = 3.40%, which is equivalent to 340 basis points.
Why Is It Important to Calculate Credit Spread?
Now that you know how to calculate credit spread, you may ponder the thought of its purpose, i.e., why it is important at all. Well, this calculation can help you come up with the best credit spread strategy. Here are some benefits of calculating credit spread.
Assessing a company’s credit quality
As stated earlier, credit spread can help in assessing credit quality. This can be beneficial for every company. Credit quality is an assessment of the creditworthiness of an entity, actually its ability to pay off its debt obligations. This includes a company’s management and the state of its assets.
The credit quality of a company can be evaluated through many different metrics. Credit spread is one of them. When the credit spread tends to be wider, the credit quality gets worse. Widening of credit spread generally indicates credit deterioration.
Another way to measure the credit quality is to look at the company’s debt-to-equity ratio or leverage ratio, which measures how much debt a company has relative to its total equity. The higher the ratio, the more likely it is that a company will default on its obligations and go out of business.
Another metric for assessing credit quality is by looking at how much cash flow a company generates from operations relative to total liabilities (or total assets). A high number here means that there are more assets than liabilities.
Estimating a company’s business performance
As a manager, you are supposed to keep track of the business performance of your company. Credit spread can be an important metric for you. Of course, you need to look into other metrics as well, including cash flow to debt ratio, quick ratio, current ratio, interest coverage ratio, and so on.
The risk of a business defaulting is often reflected in the credit spread. As a general rule of thumb, the business performance is better when credit spread is lower, and vice versa. This lowers the risk of a company’s default.
Getting insight into the cost of debt and finding the ways to reduce the credit-spread risk
If the corporate bond yield is high, the demands of the investors will probably be high too. This often leads to debt financing, which can be a costly affair for many companies, especially for long-term investments.
That affects the cost of debt financing among other things. It goes up when the credit spread is high. To reduce or minimize credit spread risk, businesses should keep a close eye on credit spread changes.