What is a credit spread?
A credit spread is the additional yield a borrower pays above a base or risk-free rate to compensate lenders for taking on credit risk. If a benchmark rate is the price of money to a riskless borrower, the spread is the premium charged for the chance that this particular borrower does not pay back in full and on time.
In a floating-rate loan, the spread is the margin quoted over the base rate — the all-in coupon is the base rate plus the spread. In a fixed-rate bond, the spread is the yield over a comparable government benchmark. Either way, the spread isolates the compensation for credit risk from the underlying cost of money.
Spreads move with both the borrower and the market. A weaker credit pays a wider spread; a stronger one pays less. And when markets turn risk-averse, spreads widen across the board even for unchanged borrowers — which is why spread levels are read as a barometer of credit conditions, not just individual risk.
How a credit spread actually works
The spread is set at pricing and then revalued continuously by the market.
- Start from the base. Take the relevant base or risk-free rate as the floor — the cost of money before any credit risk.
- Add the premium. Layer on the spread to reflect default risk, expected recovery, liquidity, and the instrument's structure and seniority.
- Reflect the credit. Riskier borrowers and more junior positions command wider spreads; stronger credits and senior, secured positions command tighter ones.
- Move with the market. Even after issuance, spreads widen and tighten in the secondary market as the borrower's risk and overall conditions change.