Definition
Credit risk is the possibility that a borrower pays late, restructures, or defaults. A credit spread is the extra yield a risky bond offers over a similar-maturity Treasury. It compensates investors for expected losses, uncertainty, and reduced liquidity.
Ratings summarize an agency's view of creditworthiness. Investment-grade bonds are rated BBB-/Baa3 or above; lower ratings are generally called high yield. Ratings can change and are not guarantees.
Why It Matters
A bond fund's yield is not free income. A wider spread may signal attractive compensation, rising fear, or deteriorating borrowers. During recessions, spreads can widen sharply and bond prices can fall even when Treasury yields decline. Income investors therefore need both yield and credit risk.
Example
A five-year Treasury yields 4.0%, while a similar-duration corporate bond yields 5.6%. Its spread is 1.6 percentage points, or 160 basis points. If the spread later widens to 260 basis points while Treasury rates stay unchanged, the corporate bond's price will generally fall.
Common Mistakes
- Treating a high SEC yield as a guaranteed return.
- Looking only at a fund's average rating and missing lower-rated holdings.
- Assuming diversification removes economy-wide default and downgrade risk.
- Confusing a Treasury-rate move with a credit-spread move.
FAQ
What is spread duration?
Spread duration estimates how much a bond portfolio may move when credit spreads change by one percentage point, similar to how interest-rate duration handles Treasury yields.
Are investment-grade funds risk-free?
No. They have lower expected default risk than high-yield funds, but still face rate, downgrade, spread, and liquidity risk.
