Credit spreads are an important warning indicator of trouble in the bond markets. Tim Bennett explains what they are and what they reveal.
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When governments borrow - by selling ‘gilts’ in the UK and ‘treasuries’ in the US - they offer the buyer a low annual return or ‘yield’, as the risk of default is virtually non-existent. Companies that borrow by issuing bonds, on the other hand, have to offer a higher yield to attract investors who are worried about the higher risk of non-repayment and the potential loss of their investment.
The gap between the higher return offered by a corporate bond and the ‘risk free’ return on a safer government bond is known as a ‘spread’. The riskier the company, the bigger - or ‘wider’ - this credit spread will be. So if the yield on gilts is 5.5% and a safe AAA rated firm offers a yield of 5.7%, the spread of 0.2% is said to be ‘narrow’ - or small. Conversely, a firm with a lower credit rating and a higher risk of default might have to offer a return of, say, 6.5% with a correspondingly wider spread of 1% over safer gilts.
• Entry from MoneyWeek’s Financial glossary.
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