What are credit spreads?
Many retail investors are familiar with bond yields, which represent the expected annual return from holding a debt instrument until maturity. Bond yields and prices share an inverse relationship: as bond prices fall, yields rise, and vice versa. To achieve higher yields, investors often turn to credit instruments – bonds that carry more risk than government securities but offer potentially greater returns.
Credit spreads, commonly referred to as simply spreads, measure the difference in yield between two bonds of similar maturity but differing credit quality. Typically, investors compare corporate bond yields against a benchmark, such as government bonds, which are considered free of credit risk. Spreads are expressed in basis points, where 100 basis points equal 1%. For instance, if a corporate bond yields 4.5% and a comparable government bond yields 3%, the credit spread is 150 basis points.
David Lanzon, CFA, Senior Portfolio Manager at ReAPS Asset Management Limited, a subsidiary of APS Bank.What do credit spreads indicate?
Credit spreads primarily reflect the additional return investors require for assuming extra risk. This risk generally falls into two categories: liquidity risk and credit risk. Liquidity risk arises from the fact that corporate bonds are generally less liquid than government bonds, meaning they may not be as easily bought or sold in the market. Credit risk reflects the higher likelihood of corporate defaults relative to sovereign issuers, prompting investors to seek compensation through higher yields.
A wider spread suggests greater perceived risk and, consequently, higher expected returns. Conversely, a narrower spread indicates lower risk and reduced return potential. The general level of credit spreads also serves as a crucial indicator of both market sentiment and economic conditions.
What influences credit spreads?
Several factors drive credit spreads, with one of the most important being the bond issuer’s creditworthiness. This is influenced by issuer-specific factors such as the ability to generate sufficient cash flow to cover interest payments and repay principal, access to alternative financing sources beyond debt, the quality of management, and the company’s commitment to meet its debt obligations.
Bond-specific factors also play a significant role in influencing spreads. The seniority of a bond’s payment structure can impact its risk level, with subordinated bonds generally carrying higher spreads due to their lower repayment priority. Additionally, whether a bond is secured by collateral or otherwise affects its perceived risk. Protective covenants, which are rules that issuers must follow to safeguard investors, can also influence how a bond is priced in the market.
Beyond issuer and bond-specific factors, macroeconomic conditions have a profound impact on credit spreads. During times of economic uncertainty or financial stress, investors demand higher spreads as compensation for increased risk. Changes in interest rates and monetary policy also play a role. When central banks raise interest rates to tighten monetary policy, borrowing costs rise, economic growth slows, and credit spreads typically widen. Conversely, during periods of monetary easing, lower interest rates reduce borrowing costs, support economic expansion, and lead to narrower credit spreads. Industry-specific risks can further influence credit spreads. For instance, bonds from the energy sector may experience wider spreads during periods of oil price volatility.
Why should investors pay attention to credit spreads?
For investors, credit spreads offer valuable insights into relative value and risk pricing in bond markets. By analysing spreads, investors can determine whether a bond is priced attractively compared to historical levels and assess how it compares to bonds with similar credit ratings. Spreads also help investors evaluate whether a bond is cheap or expensive relative to others issued by the same entity but with different maturities. Understanding these dynamics enables investors to identify bonds with attractive risk-adjusted returns. If a bond’s spread is significantly wider than justified by its credit quality, it may present a buying opportunity. Conversely, a narrower-than-expected spread could indicate overvaluation.
From a macro, top-down perspective, historical trends in credit spreads provide valuable context for investment decisions. As noted earlier, credit spreads tend to follow economic cycles, widening during downturns and contracting during periods of economic growth. During the 2008 global financial crisis, credit spreads surged as risk aversion skyrocketed, with high-yield bond spreads in the eurozone exceeding 2,200 basis points at their peak. In early 2020, credit spreads spiked due to uncertainty brought on by the COVID-19 pandemic but later tightened as governments and central banks implemented aggressive stimulus measures. More recently, credit spreads widened in early 2022 as central banks raised interest rates to combat inflation. However, as interest rates peaked and economic growth remained resilient, spreads compressed.
In recent weeks, credit spreads have widened from very low levels, reflecting a deterioration in sentiment and growing concerns over the economic outlook as fears of a trade war intensified. However, at the time of writing, markets appeared poised to reverse some of the recent widening following the United States’ decision to pause the implementation of aggressive tariffs on most countries. That said, the pause is temporary, lasting just 90 days, and leaves significant uncertainty about what may follow. This creates a volatile and challenging environment, underscoring the importance of careful bond selection and judicious allocation to credit.
Final thoughts
A strong understanding of credit spreads is essential for investors navigating bond markets, as spreads serve as key indicators of risk, return potential, and broader economic conditions. While some concepts may seem complex, grasping their implications can help investors make more informed decisions about their portfolios. In an environment where risk may be mispriced, careful analysis of credit spreads is crucial to identifying opportunities and avoiding pitfalls. By staying informed and strategic, investors can better position themselves to navigate changing market conditions with confidence. For those who find investing in bonds challenging or have limited capital to diversify effectively, professional investment managers can provide expertise in managing bond portfolios. Their experience in financial markets allows them to optimize returns while mitigating risks, making them a valuable resource for investors seeking exposure to the bond market.
The information contained in this article represents the opinion of the contributor and is solely provided for information purposes. It is not to be interpreted as investment advice, or to be used or considered as an offer, or a solicitation to sell/buy or subscribe for any financial instruments nor to constitute any advice or recommendation with respect to such financial instruments. This article was issued by ReAPS Asset Management Limited, a subsidiary of APS Bank plc. ReAPS Asset Management Limited (C77747) with registered address at APS Centre, Tower Street, Birkirkara BKR 4012 is regulated by the Malta Financial Services Authority as a UCITS Management Company and to carry out Investment Services activities under the Investment Services Act 1994 and is registered as an Investment Manager under the Retirement Pensions Act.