CREDIT SPREAD | BANK FINANCIAL MANAGEMENT | IMPORTANT FOR CAIIB 2023

CREDIT SPREAD TOPIC FOR BFM EXAM 2023

In this article, we will explain the meaning of credit spread as per the prescribed Syllabus of CAIIB BFM paper for Exams 2023.

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WHAT DOES CREDIT SPREAD MEAN?

Spread risk is not related to contractual guarantees, but rather stems from the intersection of interest rates, credit rating and opportunity costs. There are actually two types of spread risk, although they are not mutually exclusive.

1. True-spread risk, represents the probability that the market value of a contract or a specific instrument will decrease based on the actions of the counterparty. If a bond issuer defaults on its bond obligations but makes other financial mistakes that lower the issuer’s credit rating, the value of the bonds is likely to decline. Spread risk is assumed by an investor.
2. Credit spreads are the difference between the yields of different debt instruments. The lower – the default risk – the lower the required interest rate; & vice versa i.e. higher default risks come with higher interest rates. The opportunity cost of accepting lower default risk is therefore higher interest income. Spread risk is an important but often neglected component of income investing.

A credit spread is a difference in yield between a bond and another debt security having the same maturity but different credit quality. Credit spreads between Treasuries and other bond issues are measured in basis points, with a 1% difference in yield equaling a spread of 100 basis points. 

For example:

A 10-year Treasury bond yielding 5% and a 10-year corporate bond yielding 7% have a credit spread of 200 basis points. 

Credit spreads are also referred to as bond or default spreads. A 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 an option having a high premium and an option with a low premium is bought on the same underlying security. This gives credit to the account of the person who makes 2 trades.

Let us understand how Credit Spreads work with the help of Bonds and Options:

Credit spreads for bonds

The bond credit spread reflects the difference in yield between a government bond and a corporate bond with the same maturity. Debt issued by the Treasury Department is used as a benchmark in the financial industry because it is risk-free and backed by the full faith and credit of the country’s government. Government bonds are considered the closest to a risk-free investment because the probability of default is almost = 0. Investors have maximum confidence in repayment.

Corporate bonds, even for the most stable and highly rated companies, are considered riskier investments for which the investor requires compensation. This compensation is the credit spread. 

Credit spread (bond) = (1 – rate of return) * (default probability)

VARIATION IN CREDIT SPREADS

The credit spread varies from 1 security to another based on the credit rating of the bond issuer. 

Higher-quality bonds, which are less likely to default on the issuer, may offer lower interest rates while Lower-quality bonds with a higher probability of issuer default must offer higher rates to attract investors to a riskier investment. 

Fluctuations in credit spreads are usually caused by changes in economic conditions (inflation), changes in liquidity, and demand for investments in specific markets.

For example: 

When investors face uncertain or worsening economic conditions, they tend to flee to the safety of Govt. Treasuries (buy) often at the expense of corporate bonds (sell). This dynamic causes Treasury prices to rise and yields to fall, while corporate bond prices fall and yields to rise. The expansion reflects investor concerns. This is why credit spreads are found to be a good barometer of economic health – widening (bad) and narrowing (good).

There are a number of bond market indices that investors and financial experts use to track the yields and credit spreads of various types of debt with maturities ranging from three months to 30 years. Some of the most important indexes include high-yield and investment-grade corporate debt, mortgage-backed securities, tax-exempt municipal bonds and government bonds.

Credit spreads are wider for debt issued by emerging markets and lower-rated corporations than for government agencies and wealthier and/or stable countries. Spreads are larger for bonds having longer maturities.

WHAT IS THE DIFFERENCE BETWEEN RISKS OF FAILURE & CREDIT SPREAD RISK?

Default risk and spread risk are two components of credit risk, which is a type of counterparty risk. Think of default risk as more closely related to the general concept of counterparty risk i.e. failure to meet the specifications and terms of the contract. 

Spread risk can be related to investment risk. Ex: when the price or yield changes due to a change in credit rating.

Credit spread risk is not the same as the risks associated with a credit spread option, although there are credit spread risks with a credit spread option. 

Credit spread options are a kind of derivative where one party transfers credit risk to another party- in exchange for a promise to make cash payments if the credit spread changes. This type of agreement is most common with debt securities that have a low credit rating.

Default risk

Almost every single loan or credit extension comes with some form of default risk. Default risk is measured by the probability that an individual or company will not make contractual payments on a debt obligation. The risk of default does not exist in financial transactions such as stock purchases that do not have a guarantee of payment.

As a simple example of default risk, consider a borrower who takes out a $300,000 home loan. The bank that granted the loan does not know for sure whether the borrower will repay the loan on time, and therefore assumes the risk of default during the transaction. To compensate for the risk of default, an interest rate is applied to the loan and the bank may also require a substantial deposit.

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