What are credit spreads?

Credit spreads measure the additional yield (premium) that investors demand for holding corporate bonds instead of risk-free government bonds of the same maturity. This premium compensates investors for the risk that the corporate issuer may default on its debt obligations. Wider spreads indicate higher perceived risk; tighter spreads indicate confidence in corporate creditworthiness.

The most commonly tracked credit spread measures are the ICE BofA High Yield OAS (option-adjusted spread) for below-investment-grade (junk) bonds and the ICE BofA Investment Grade OAS for higher-quality corporate debt. High yield spreads are more sensitive to economic conditions because lower-rated companies are more vulnerable to default during downturns.

Credit spreads serve as a real-time barometer of financial stress. During normal economic conditions, high yield spreads typically range from 300 to 500 basis points. Above 500 basis points signals meaningful stress. Above 800 basis points indicates crisis-level pricing, as seen during the 2008 financial crisis (over 2,000 bps) and the March 2020 COVID shock (roughly 1,100 bps). Conversely, spreads below 300 bps suggest risk-on conditions and potentially complacent pricing.

The relationship between credit spreads and equities is important for cross-asset analysis. Widening credit spreads often lead equity weakness, making them a valuable early warning signal. During the 2007 bear market, credit spreads began widening months before the S&P 500 peaked. This lead-lag relationship exists because bond markets tend to be more forward-looking and less influenced by momentum-driven retail flows than equity markets.

For the Fed, credit spreads are a key component of financial conditions. Rapid spread widening tightens financial conditions, effectively doing part of the Fed's tightening work for it. Conversely, tight spreads represent easy financial conditions that may offset the intended restrictiveness of high policy rates. Understanding credit spreads provides insight into the true stance of monetary policy as experienced by businesses that need to borrow.