What is credit spread?

In banking jargon the word ‘spread’ is used in issuance of corporate bonds,interest levied on loans and in foreign exchange transactions. In foreign exchange transactions the difference between the buying rate and selling rate is referred as spread or margin.  The term ‘credit spread’ is used in the fixed income corporate bonds and bank loans. It is the risk premium add-on to the base interest rate used when pricing corporate debt issues. In bank loans credit spread (known as pricing) is used over base rate or MCLR. The spread is determined on the perceived loan repayment or prospects of bond repayment to the investors. The risk involved in repayment is called default risk. When corporate bonds are issued, the pricing of the bond mirrors the credit rating or risk rating of the company, the maturity of the issue, current market spread rates, as well as other components such as security and liquidity. In bank loan spread is determined on the basis of whether the loan is sanctioned at fixed rate of interest or floating rate, whether the loan sanctioned is supported by collateral security etc.

The ‘Credit spreads ‘may ‘widen’ or ‘tighten’ as a sign of the perceived capability of the borrower to pay its scheduled interest and principal payments on time and  in bonds market the changing risk profile of the issuer. Credit spreads vary both on account of security provided as well as credit rating of the borrower.  For example a company of higher rating offer lower rate of interest than a bond issuer company of lower ratings and the Banks widen spread on their advances perceived with higher risks compared to a company of lower risk with higher ratings.