Credit spread
Also written Yield spread · Credit spreads · Spread over gilt
The extra yield a non-government borrower must pay over a government security of the same tenor — the market price of credit risk, quoted as an add-on over the risk-free rate.
In plain language
A sovereign borrowing in its own currency cannot be forced to default; it can print the money. So the rate it pays is called the risk-free rate, and the yield on a gilt is the lowest available for any given tenor.
Everybody else can default. So everybody else pays more, and the difference is the credit spread. The workbook defines it twice, from two directions, and they mean the same thing: the difference between the yield on a gilt and the yield on a non-government debt security of the same tenor, and the add-on over the risk-free rate that a borrower is charged for its credit rating.
It is quoted as a spread rather than a rate for a practical reason: the risk-free curve moves for everyone at once, and the spread is the part that belongs to this particular borrower.
How it works
Spreads are grouped by credit rating and vary by tenor, so a borrower faces not a spread but a curve of them. The workbook's hypothetical table:
| Term | Risk-free rate | AAA | A | BBB |
|---|---|---|---|---|
| 1 month | 5.00% | 0.15% | 0.25% | 0.35% |
| 3 months | 5.25% | 0.25% | 0.50% | 0.75% |
| 1 year | 5.75% | 0.40% | 0.75% | 1.10% |
| 5 years | 6.50% | 0.85% | 1.50% | 2.25% |
Read down a column and the spread widens with tenor — the longer you lend, the more can go wrong. Read across a row and it widens with poorer rating. Plot any row set against the terms and you have a "risk-free curve", an "AAA curve", a "BBB curve".
For a debt fund, spreads are a second source of return alongside interest rates. The workbook is explicit that returns in a debt portfolio are driven by both. A security whose rating is upgraded is re-priced at a lower spread, and the market will now accept a lower credit spread, so the value of the security rises. A fund manager who anticipates that upgrade captures the gain; if the re-rating does not come, the portfolio is left holding the default risk instead.
Spread widening is also what a credit-event looks like in prices — a default, a delay, or a downgrade, any of which reprices the paper downwards.
The formula
Credit spread = Yield on corporate bond − Yield on gilt of the same tenor
Borrowing rate = Risk-free rate + Credit spread
Approximate price impact of a spread change:
% change in price ≈ − Modified duration × Change in spread
A worked example
The risk-free rate is 8.25%. The workbook's spreads: 0.10% for AAA, 0.25% for AA.
AAA borrower pays = 8.25 + 0.10 = 8.35%
AA borrower pays = 8.25 + 0.25 = 8.50%
On a Rs 10 crore issue, that 15 basis points is Rs 1.5 lakh a year — the whole of it the price of one rating notch.
Now take the five-year row from the term table. A debt scheme holds Rs 10 crore face value of five-year paper:
| Rating | Yield | Annual coupon on Rs 10 crore |
|---|---|---|
| Gilt | 6.50% | Rs 65.0 lakh |
| AAA | 6.50 + 0.85 = 7.35% | Rs 73.5 lakh |
| A | 6.50 + 1.50 = 8.00% | Rs 80.0 lakh |
| BBB | 6.50 + 2.25 = 8.75% | Rs 87.5 lakh |
Rs 22.5 lakh a year separates the gilt from the BBB paper on an identical maturity. That gap is not free money; it is the market's estimate of what it costs to be wrong about the borrower.
And the capital gain. Suppose the A-rated paper is upgraded to AAA. The spread falls from 1.50% to 0.85% — a tightening of 65 basis points. At a modified duration of about 4.2:
Price change ≈ 4.2 × 0.65% = 2.73%
On Rs 10 crore = Rs 27.3 lakh
Rs 27.3 lakh in a single re-rating, against a Rs 6.5 lakh annual yield advantage the position was earning. That is why the workbook treats anticipating rating changes as a distinct portfolio strategy — and notes in the same breath that if the re-rating does not materialise, the fund is simply carrying more default risk.
Why NISM asks about it
Chapter 18.5 defines the credit spread against the risk-free rate and supplies the 8.25%/0.10%/0.25% illustration; Chapter 18.6 gives the term-structure table of spreads by rating; Chapter 10 treats credit spreads as one of the two drivers of debt fund returns and covers the re-rating gain. Expect a computation of a borrowing rate from a spread, and a conceptual question on what happens to a bond's price when its rating improves.
Common exam traps
- A spread is measured against a gilt of the same tenor. Comparing a five-year corporate with a one-year gilt is not a credit spread.
- Spreads widen with tenor as well as with poorer rating. The workbook's table moves in both directions.
- A rating upgrade narrows the spread and raises the price. The inverse yield-price relation catches candidates who reason from the yield alone.
- Credit spread risk and interest rate risk are separate. The gilt curve can fall while spreads widen, and the bond still loses.
- The risk-free rate is free of credit risk, not of all risk. Market risk and reinvestment risk survive; only a zero-coupon sovereign held to maturity is free of all three.
- Do not confuse it with the option strategy called a credit spread, which is a two-leg option position and has nothing to do with credit at all.
Where this is taught
- Series X-A · Chapter 7: Introduction to Investmentsintroduced here
- Series V-D · Chapter 10: Risk, Return and Performance of Fundsintroduced here
- Series IV · Chapter 1: Introduction to Interest Rate, Interest Rate Instruments and Fixed Income Marketsintroduced here
- Series XII · Chapter 2: Securities: Types, Features and Concepts of Asset Allocation and Investingintroduced here
- Series V-D · Chapter 18: Introduction to Interest Rate, Interest Rate Instruments and Fixed Income Markets
Related terms
- Credit ratingAn opinion on how likely a borrower is to service an instrument on time, reduced to a symbol by a SEBI-registered rating agency — and reviewed continuously, not fixed for the life of the bond.
- Credit riskThe risk that a borrower fails to meet its obligations on a debt instrument — the risk credit rating agencies exist to grade, and the one that triggers a segregated portfolio in a mutual fund.
- Modified DurationMacaulay's duration divided by (1 + yield) — the percentage by which a bond's price moves for a one percentage point change in interest rates, and so the standard measure of interest rate risk.
- Yield to MaturityThe single discount rate at which a bond's future coupons and redemption amount add up to exactly its market price today — the return you actually earn if you hold it to maturity.
- Government SecurityA tradeable debt instrument issued by the Central Government or a State Government — treated as free of default risk, and the benchmark against which other rupee interest rates are priced.
- Risk-free rateThe rate on a sovereign borrowing in its own currency, where credit risk is absent because the government can print the money — the benchmark every other valuation is measured against.
- Corporate Bond Index FuturesCash-settled futures on an index of corporate debt rated AA+ and above, permitted by SEBI in January 2023 to give the corporate bond market a hedge of its own.
- Term structure of interest ratesInterest rate plotted against term — one curve per credit quality, with the risk-free curve as the base and every other borrower quoted as a spread over it.