A credit spread is the difference in yield between a non-Treasury bond and a Treasury security of the same maturity. It represents the additional compensation investors demand for bearing credit risk, specifically the possibility that the issuer may default or be downgraded.
Credit spreads vary by:
A credit spread compensates investors for three distinct risks, not one.
Expected loss reflects the probability of default multiplied by the loss given default. For a BBB-rated issuer, the 5-year cumulative default probability runs roughly 1.5% to 2.5%, with historical recovery rates near 40 cents on the dollar. That implies an expected loss of approximately 15 to 25 bps per year, forming the floor of a BBB spread.
Unexpected loss premium compensates for the risk of correlated defaults during a stress event. In a recession, defaults do not occur independently. A portfolio of BBB credits may experience simultaneous downgrades, forcing institutional sellers into the market at the same time. Investors demand a premium above expected loss to hold this tail risk.
Liquidity premium accounts for the fact that corporate bonds trade far less frequently than Treasuries. A portfolio manager exiting a large corporate position may wait days for a market-clearing bid, accepting a price concession. The yield pickup for illiquidity is especially pronounced in lower-rated and smaller-issue bonds.
These three components are not directly observable in isolation. What the market quotes as a spread bundles all three, and their relative weights shift across the credit cycle.
The following ranges are approximate and cycle-dependent. Spreads compress at cycle peaks and blow out in downturns.
Investment grade:
High yield:
Maturity extends spreads at every rating. A 10-year BBB credit will generally trade 20 to 40 bps wider than a 5-year BBB credit from the same issuer, reflecting additional default exposure and lower liquidity in the longer tranche.
Credit spreads are procyclical. They tend to be tightest late in an economic expansion, when default rates are low and investor risk appetite is high, and widest during recessions, when defaults cluster and liquidity evaporates. Investment-grade spreads exceeded 600 bps in late 2008, a level that implied severe systemic stress far beyond what historical default rates would justify.
The interaction between credit spreads and Treasury yields is an important and often underappreciated dynamic. During an expansion, rising Treasury yields typically accompany spread tightening, as growth expectations improve credit quality perceptions. During a downturn, falling Treasury yields coincide with spread widening, as the Fed cuts rates in response to deteriorating conditions. The two effects can partially offset each other, making the all-in corporate yield more stable than either component alone.
This is why portfolio managers track both the Treasury curve and the credit spread independently. A tightening in spreads of 50 bps that coincides with a 50-bp rise in Treasury yields leaves the corporate bondholder's total yield unchanged, but the composition of risk has shifted entirely.
What is a credit spread?
A credit spread is the yield difference between a corporate or non-government bond and a Treasury security of equal maturity. It measures the market's pricing of credit risk, liquidity risk, and default uncertainty above the risk-free rate.
How do credit spreads relate to Treasury yields?
A rise in Treasury yields does not automatically raise corporate borrowing costs if credit spreads tighten simultaneously. The total yield on a corporate bond is the sum of the Treasury yield and the credit spread. When an economy strengthens, Treasury yields may rise 50 bps while spreads tighten 40 bps, resulting in a net increase in corporate borrowing costs of only 10 bps. The reverse holds in downturns: the Fed cuts rates aggressively, but spreads widen sharply, leaving corporate borrowers facing higher all-in yields despite lower policy rates. Tracking both components separately is essential for any credit analysis.
What does it mean when credit spreads widen?
Widening spreads signal that investors are demanding greater compensation for credit risk, typically due to deteriorating economic conditions, rising default expectations, or a broad reduction in risk appetite. Spread widening often precedes or accompanies equity market declines and can appear in credit markets before macro data confirms a slowdown.
How are credit spreads measured?
Credit spreads are quoted in basis points. The spread is calculated by subtracting the Treasury yield at the matching maturity from the corporate bond yield. The levels page on YieldCurve.pro plots the Treasury benchmark yields used as the risk-free reference in this calculation.