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Why You Should Care About Credit Spreads

A bond credit spread is the extra yield that investors receive for investing in bonds that are less safe than U.S. Treasuries.

Why should you care?

When the credit spread is greater than the extra risk, it make sense to buy more-risky bonds. Also, a rise in corporate credit spreads can be a strong signal that the stock market is about to have a correction.

The mainstream financial media mainly focuses on current interest rates when discussing the bond market. While this does provide some value, it’s also kind of like looking at the price of a house without considering the neighborhood where it is located. By looking at credit spreads in addition to the current level of interest rates, a bond investor gains extra context — and an understanding of how credit spreads change over time can provide investors some insight that can be turned into potential profits.

The Basics of Credit Spreads

When bond investors discuss credit spreads, the large majority of time they are talking about the difference in interest rates between corporate bonds and Treasury bonds with the same maturity.

U.S. Treasuries are considered by most investors to be free from default risk. For corporate bonds, on the other hand, default risk is a primary concern. By comparing the interest rate of a Treasury security to the interest rate of a corporate bond with the same maturity, investors get a picture of how much credit risk the market associates with an individual bond or group of bonds. You can learn more about the basics of bond credit spreads here.

Credit Spreads Change Over Time & We Are Not Close to Historical Lows

Below is a chart showing the credit spread for the investment-grade bond market as a whole.

As you can see from this chart, as the economy fluctuates, so do credit spreads. During the 2004-to-mid-2007 period when the economy was growing nicely and investors were optimistic, the credit spread was low (around 1%). At the height of the financial crisis, however, credit spreads widened out substantially, as investors demanded a much higher premium for taking on the additional credit risk of corporate bonds.

We also can see that although interest rates in general are close to all-time lows, we are nowhere near historical lows in terms of the credit spread.

In other words, relative to the other houses in the neighborhood, investment-grade corporate bonds could still be considered “cheap” compared to Treasuries by historical standards, meaning interest rates on corporate bonds could fall even further. You can learn more about how credit spreads change over time here.

What else can we learn from this chart?

Bond investors are not the only ones that can benefit from an understanding of bond credit spreads. In fact, the movement of credit spreads over time can provide a lot of clues for stock investors as well. Below is a chart of the SPDR S&P 500 ETF (NYSE:SPY), which tracks the price performance of the S&P 500 Index. As you can see, the stock market topped and began its historic sell-off in mid-October 2008.

Now, take a look at the same chart of investment-grade credit spreads that I have shown above, zoomed in on 2007. As you can see from the chart, while stock investor optimism continued through mid-October, credit spreads started and continued to widen out a couple of months earlier.

Credit spreads not only provide valuable additional context for bond investors, but can have some forecasting power that can be used to stock investors’ advantage as well. If you visit the St. Louis Fed’s website and run these graphs for yourself, I think you will find that 2007 was not the only time where stock investors could have gained an edge by following bond market credit spreads.

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