With this credit spread calculator, you can easily calculate the credit spread of a corporate bond before you make your investment decision. Credit spread is one of the most common metrics to assess the quality of a company's credit and the bonds it issues.

This article will help you to understand what is a credit spread with the credit spread definition. We will also demonstrate how to calculate the credit spread of a company using the appropriate formula. This article will also include an example to help you understand how to implement the a credit spread strategy in real life.

What is a credit spread? The credit spread definition

It is difficult to understand what is a credit spread without first understanding the meaning of yield to maturity (YTM). In short, YTM is defined as the total return an investor will gain if the bonds are held to maturity. It can be interpreted as how much the bonds the company has issued cost. The riskier the bond is, the higher the probability of default, and so the higher the YTM will be as investors will require a higher return to be convinced invest in the risky bonds.

The credit spread definition is essentially the difference in YTM between a corporate bond and a government bond with the same maturity. It is a measure that most investors use to assess the credit quality of corporate bonds trading in the market.

As most government bonds are deemed credit risk-free, they are used as a benchmark which corporate bonds are compared against. The wider the credit spread, the worse the company's credit quality. When a company's credit quality drops, credit spread widening will happen to reflect the required return investors demand.

Let's now talk about how you can calculate the credit spread of a company.

How to calculate the credit spread of a corporate bond using the credit spread formula?

Let's look at an example to understand the credit spread calculation using the following information:

  • Corporate bond yield: 5.3%;
  • Government bond yield: 1.8%;
  • Number of years to maturity of the corporate bond: 10 years; and
  • Number of years to maturity of the government bond: 10 years.

The credit spread calculation is straightforward. There are only 3 steps involved:

  1. Determine the yield to maturity of the corporate bond

This information can be found on most financial websites, such as Vanguard, Yahoo Finance, Fidelity, etc., as most corporate bonds are quoted by their yield to maturity. Alternatively, you can also get this information by pouring through the company's annual report; most companies will record the details of their bond issuance in their annual report.

In our example, the corporate bond yield is 5.3%.

  1. Determine the yield to maturity of a similar government bond

The yield to maturity of the government bond is also a piece of easily accessible information. The most direct way of getting this information is to perform a web search. You can also go to the relevant government website. For instance, if you are looking at the US bond market, you can visit the Federal Reserve website. If you want to invest in the UK bond market, the Bank of England website will be your top choice.

However, do note that you need to compare the corporate bond to a government bond with the same maturity.

In our example, the government bond yield is 1.8%.

  1. Calculate the credit spread

The last step is to calculate the credit spread. This can be done by using the credit spread formula below:

credit spread = corporate bond yield - government bond yield

Hence, the credit spread in this example is 5.3% - 1.8% = 3.5% = 350 basis points.

Are you unsure what the basis point in the credit spread formula means? Check our basis point calculator to find it out!

The purpose of calculating credit spread

Understanding the purpose of calculating credit spread is vital to formulate a credit spread strategy. The following are a few examples:

  1. Assessing the credit quality of a company

As mentioned above, credit spread helps assess the credit quality of a company. The wider the credit spread, the worse the company's credit quality. Thus, credit spread widening often signals a deterioration in the company's credit quality. It is essential that you pay attention to the credit spread before investing in corporate bonds.

  1. Assessing the business performance of a company

Credit spread is often tied to the business performance of the company. Credit spread reflects the risk of a company defaulting. The higher the company's credit spread, the worse its performance is, which increases the risk of default. Hence, credit spread is also an important metric in assessing the performance of a company.

  1. **Understanding the ** cost of debt financing and how to limit the credit spread risk

The higher the corporate bond yield, the more the investors require in return. This makes it more expensive for a company to finance through debt. So, in general, the higher the credit spread, the higher the cost of debt financing. It is important for a company to closely monitor changes in their bonds' credit spread to limit credit spread risk.

Last, but not least, it is crucial to understand that credit spread is not the only metric to assess the credit quality of a company. You should look into metrics such as current ratio, quick ratio, cash flow to debt ratio, and interest coverage ratio to make informed investment decisions.

Wei Bin Loo
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