In bond finance, the term credit spread denotes the difference between the interest rates of 2 different bonds or groups of bonds.
Typically, this term is used in relation to government bonds. The credit spread, in this case, is the difference between the interest paid by one government to holders of its bonds and that paid by a different government to holders of its bonds.
Example of a credit spread:
Government 1 issues a bond with a fixed interest rate of 1% per annum. Because the country has a strong economy and good creditworthiness, investors are willing to buy these bonds even though the interest paid is low, because they feel assured that the government will pay the interest and repay the principal as agreed. The stronger the demand for this country’s bonds becomes, the less interest the government will have to offer in order to attract investment.
Government 2 is having difficulty attracting investment because the country’s economy is struggling and its credit ratings are poor. Investors are leery of investing in the government because they are not sure whether the government will be able to pay interest and repay the bond principal when the bond matures. To encourage investment, the government issues a bond with a high 6% fixed annual interest rate. The lower the demand for this country’s bonds becomes, the more interest the government will have to offer in order to attract investment.
In the example above, the difference between the 1% interest rate offered by Government 1 and the 6% interest rate offered by Government 2 is the credit spread. In this example, the credit spread between Government 1 bonds and Government 2 bonds is 5%.
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