Credit spread
What is it?
An indigestible sandwich filler. The term credit spread refers to the difference between the amount of money an investor in a risky bond can expect to receive in regular payments and the returns paid out on a bond which is considered a much less risky investment.
First of all, the risky bond - let's say it costs the buyer $100 and has to be repaid after three years. But the company that issued the bond isn't very financially sound and there's a risk it may never pay the bond off when the three years are up. As a result, that company pays the holder of the bond $15 a year just to keep them happy.
By comparison, a bond which costs $100 but was issued by the US Treasury (and which, until recently, was not considered to be risky at all) might pay only $5 a year to its owner.
Credit spreads are usually explained in basis points, or 100ths of a percentage point. In the example above, the spread is therefore huge - while the yield on one bond is 15%, the yield on the other is only 5%. The spread between the two is therefore 10%, and would be referred to as a spread of 1,000bp (basis points).
What's it got to do with the financial crisis?
In the years preceding the credit crunch, credit spreads narrowed hugely - ie, the difference between the payouts on a risky bond and the payouts on non-risky bond fell.
The long-term average credit spread between very risky so-called 'junk' bonds and American treasuries is 500 basis points, according to the Economist. But in March 2007, the spread between them was only about 280 points. By March 2008, the spread exceeded 800.
Credit spreads have risen since the credit crunch turned nasty. Investors now want more reward for holding what are suddenly perceived to be very risky assets. Before the crunch nothing was seen as particularly risky (you could say that investors were lulled into a false sense of security), so investors were happy not to be paid higher returns for holding bonds whose issuers might never pay them back.
Last updated on 26 September 2008.
