Credit Spreads | Barita Insights | December 19, 2022

Introduction
What are Credit Spreads? A Credit spread is the difference in the yield of fixed-income securities, with similar maturities but different credit quality. The yield of a fixed income is the return on an instrument relative to its par value. The credit spread is often an indication of the risk premium an investor will/can receive for investing in a credit of lower security or quality. An example of this would be a 10-year US treasury yielding 4% and a 10-year Corporate Bond yielding 8%. The credit spread between the two instruments would be 4%, measured as 400 basis points (100 basis points being equal to 1%). The higher yield on the corporate bond is a result of the increased risk associated with the exposure relative to the US government bonds, which are considered effectively risk-free, due to the extremely low likelihood of default. The fixed-income market, particularly the bond market, is closely watched by investors as it can be an indicator of short to medium-term economic stress. This is partly because of the ‘reflexive feedback mechanism’ in corporate fixed-income securities, in which the fear of default causes yields to rise, increasing refinancing risk, and thus increasing the likelihood of default. Since companies are more likely to default amidst a slowing economy, their related credit risk increases.

Credit Spreads and Investor Sentiment
Generally, credit spreads tighten when improving economic conditions are expected and widen when economic conditions are expected to worsen. In market downturns, investors typically allocate funds and shift portfolio exposure to less risky investments, creating a demand for lower-risk securities such as US Treasury Notes. The price and yield of fixed-income securities have an inverse relationship, denoting that as the price for US treasury notes increase the yield decreases. As the demand for these securities increase, the price also increases, as investors are willing to accept a lower yield for lower risk. Conversely, higher-risk fixed-income securities such as high yield corporate debt experience an increase in yield relative to government securities, as investors rotate to safer assets, dampening demand for these securities. This creates a widening of credit spreads, usually indicating heightened risk in the overall credit market and worsening economic conditions. In a market upturn, usually aided by a low-interest rate environment, systematic risk tends to decline amidst improved conditions, as such, a general decline in interest rates typically materializes. Against this backdrop, the demand for yield drives an increase in the appetite for riskier fixed-income securities relative to treasuries, which contributes to a narrowing of credit spreads. Narrowing credit spreads suggest that there is less risk in credit markets, as low rates allow companies to access capital at cheaper rates, and therefore, fueling potential growth. Typically, a tightening of credit spreads usually creates tailwinds for the equities market. As the cost of debt capital decreases, the discount rate also decreases as the compensation for risk in equities is weighed against that of the fixed income market.

An example of this would have been seen in March 2020 when the Covid-19 virus first made strides outside China’s borders. As the probability of default in corporate debt began to increase, spreads widened significantly as investors flocked toward US Treasuries and Investment Grade Corporate Bonds. This, however, was short-lived as the Federal Reserve through its monetary policy toolkit simultaneously initiated quantitative easing and cut its policy rate. This saw the Fed expanding its balance sheet, primarily with the purchase of government securities. This caused credit spreads to contract quickly, as the yields on risk-free assets decreased, causing investors to seek yield in higherrisk securities. Coinciding with the historically low rates in the high yield and investment grade markets, the S&P500 saw its highest returns since 2013, amidst a pandemic with the 2021-year-end return totaling 26.61%. As inflation began to loom, stemming from the pandemic related supply shock and fiscal stimulus by the US government, credit spreads started to widen, as it became clear to investors that the Fed would eventually have to increase their policy rate, and risk in credit markets would re-emerge as short-term borrowing costs increased.

Conclusion
Credit spreads generally indicate the additional risk that lenders take when they buy corporate bonds compared to government securities of the same maturities. Spreads can also be used to compare relative value or conditions in corporate bonds of different credit quality to assess the value of investment opportunities within the context of the broader the economic climate. Though the spreads between corporate and government securities are not a holistic economic indicator, the relative appetite for fixed income of varying quality and the level of accompanying risk exhibited in the bond markets can be incorporated with other information to extract insight as to where investors perceive current and future market conditions.