Credit spread

The difference between a bond's yield and that of a government bond of the same currency and maturity. It is the market's price for the default risk, the illiquidity and any adverse options the government bond does not carry.

Example

A corporate bond yielding 5.9847% against a 3.60% government bond of the same maturity carries a spread of 2.3847 percentage points, or 238 basis points.

Important

Convert it into a break-even default rate before deciding it is generous: at a 40% recovery, 238 basis points breaks even at 3.9745% a year, or 24.7155% cumulatively over seven years. That turns a yield into a proposition you can disagree with.

Related terms

• Credit risk — The risk that an issuer fails to make a contracted payment. It is the risk most associated with bonds and, for high-quality issuers, rarely the one that moves the price.
• Recovery rate — The proportion of a claim a creditor actually receives after a default, once the borrower's assets have been realised and distributed in rank order.
• Credit rating — An agency's published opinion on the relative likelihood that a specific obligation is repaid, expressed on an ordinal scale and usually paid for by the issuer.
• Basis point — One hundredth of a percentage point. A move from 4.00% to 4.25% is 25 basis points; a move from 4.00% to 6.00% is 200.

Lessons that explain it

• Appraising one bond: three yields that disagree, and what the rating leaves out — A single bond has a coupon rate, a current yield and a yield to maturity, and they are three different numbers. The gap between the last of them and a government bond is the market's own estimate of what could go wrong. (13 min)
• A loan's rate is a stack: base rate, expected loss, illiquidity and fees — Private loans are priced by building up from a risk-free rate, adding compensation for defaults, for being unable to sell, and for the intermediary. Values between lending and repayment are mostly estimates. (11 min)

All 578 terms in the Investing glossary