I need a break from the math, so let’s head back to elementary school.

As mentioned in the intro post, how much you would pay for a bond depends on many factors, and they can get complicated. So we simplify things by considering pairs of bonds that differ in only one aspect, and then looking at the difference between their market-determined yields. The difference between two yields is called a spread.

For example, if you were considering buying one of two bonds with identical face values, maturities, coupon payments, and payment schedules, but they came from different issuers, how would you decide which one was worth more to you? Since a bond is merely a promise to give you money in the future, you would base your decision on how much you trusted each issuer. That is, you would demand a higher yield (i.e., offer a lower price) for the bond from the issuer you considered less trustworthy.

The bond market as a whole makes these decisions in the same way, and the term for this particular kind of trust is credit. (It is a very old concept; the word derives from the Latin credo, credere, meaning “to trust” or “to believe”.) Being able to borrow at low rates of interest is the definition of good credit.

Like trust, good credit and bad credit are relative. If you take the difference between the yields of two otherwise identical bonds that differ only in their issuers, you obtain the credit spread between those issuers.

Brief terminology detour: Because interest rates are small numbers, spreads are even smaller numbers, often less than one percent. The bond market has a term for 1/100 of one percent: basis point, abbreviated bp (pronounced “bip”). If a bond trader gives a spread but omits the units, he or she means basis points.

More terminology: When a spread is small (or shrinking), it is said to be tight (or tightening). If a spread is large (or growing), it is said to be wide (or widening).

Now, if only there were an issuer that were perfectly trustworthy, we could talk about credit spreads in an absolute sense; that is, we could isolate credit from all of the other factors that go into pricing a bond. For U.S. dollars, there is such an issuer: The United States Treasury. (We are assuming that the U.S. Treasury is absolutely, positively going to repay its debts as denominated in U.S. currency. This is the customary assumption, so we will run with it.) Bonds from the U.S. Treasury are called Treasury bonds or simply Treasuries.

Since the Treasury has perfect credit, yields on Treasuries capture every concern of the bond market — opportunity costs, inflation risks, etc. — except for credit. All of those other concerns are identical for any bond with the same maturity, coupon, etc.; the only concern that is specific to the issuer is credit. Therefore, we can isolate the credit of any issuer by comparing the yield on its bonds to the yield on comparable Treasuries.

For bond traders, this is a very common way of thinking and talking. For example, on Friday John Jansen wrote:

Bunge (an agricultural and food company) sold $500 million 10 year bonds yesterday at T + 479. They traded before the Labor report at 435 and are currently 425 bid. We have now covered enough ground to decipher this. Because he is discussing prices, he is talking in yields; “T” means Treasury yield; and the omission of units means basis points. He says that Bunge sold bonds on Thursday with 10-year maturity and a total face value of$500 million for a yield 4.79% higher than comparable Treasuries. The only economic news on Friday morning was the May employment report from the Bureau of Labor Statistics. Prior to that news release, the spread on those Bunge bonds had already fallen to 4.35% above Treasuries; that is, the bonds had become (relatively) more expensive. And at the time of the post, there was a bid in the market to purchase them at an even tighter spread (4.25%).

Since the yield on any bond can be thought of as a Treasury yield plus a credit spread, if the yields on Treasuries should change, the yields on all dollar-denominated bonds will change with them. So when people talk about “interest rates” in general going up or going down, they are talking about Treasury yields, from which all others follow based on their credit.

Next time: Treasuries and the yield curve.

• rortybomb

This is great. I’d tangent this discussion to talk about recovery, and implied default rates from the credit spread. Something like S = d(1 – R + r).

• Thanks, Mike. I would love to head that direction — briefly — if I felt like I understood it.

Do you happen to have a reference?

• rortybomb

This is great paper: http://www.faculty.virginia.edu/wei_li/em/jpm-default-prob.pdf

Also if you have Hull’s “Options…” the credit risk chapter.

There’s a lot of debate about how ‘clean’ this information is present in market information (also see the information content of CDS spreads), but as a first approximation it might be helpful for readers to understand some theory on where a credit spread comes from.

• “Everything should be made as simple as possible, but no simpler.”

I agree, and I promise to do a “Credit Spreads II” post at some point, just as soon as I feel qualified to write it :-). (Or maybe I will make it more interactive, since I am rapidly approaching the limits of my own knowledge. I may need to do this anyway when I try to tackle rate swaps.)

Maybe “Credit Spreads II” could also include a few words about CDS?

Anyway, it will happen eventually. But not next. Jansen tracks the yield curve morning, noon, and night, and I want get that basic stuff out of the way first.