Credit Spreads: Under the Radar, but Influential

Even if the subject doesn't sound exciting or relevant for every trader, the concept is important to understand because it can serve as a broader-market barometer.

The amount of spread varies by issuer. Higher-rated, investment-grade corporate bonds tend to offer lower spreads because they typically are less risky investments, while high-yield bonds, or sub-investment-grade bonds, offer much higher spreads to compensate investors for their perceived bigger risks.

The average spread of the Bloomberg U.S. Corporate Bond Index was 1.3% over the 15 years leading into 2025 compared to 4.5% for the Bloomberg U.S. Corporate High-Yield Bond Index. That means investors holding investment-grade corporate bonds tend to get paid yields about 130 basis points above the yield offered by a Treasury note of the same length as the corporate bond, while those holding high-yield bonds were collecting, on average, a yield of 450 basis points more than the Treasury-backed counterpart. Depending on the economic environment, actual spreads could be more or less than the 130-basis point average.

The average spread, or premium, between this high-yield bond index and Treasury yield has ranged from under 3% to above 7% over the last five years, according to a five-year weekly chart of ICE BofA US High Yield Index. It peaked in 2020 during the pandemic, rose again in 2022 when U.S. inflation surged and stocks cratered, and reached its lowest level of the span in late 2024 as the Federal Reserve cut rates and stocks rallied to new records amid the U.S. economy's strong growth.

Credit spreads can matter for a specific company or for the overall economy. Both the broader economic outlook and a company's specific earnings prospects are fundamental factors that tend to affect a company's spread.

If the spread of a given company's bonds begins to rise, that usually suggests concerns about the company itself. If earnings are expected to slow, for example, prospective bondholders might demand higher yields to compensate for the increased risk of a failed repayment.

"If things are good for the economy or the specific company selling a bond, investors generally don't demand much spread," Martin said. "If that outlook changes, investors get a bit nervous and want additional yield to compensate for the risk of default."

Rising spreads won't necessarily mean the company must pay higher borrowing costs immediately, but it can make it more challenging to refinance existing debt.

"Spreads are often viewed from an aggregate standpoint—what's the average spread of the overall corporate market doing?" Schwab's Martin said. "If the economic outlook is deteriorating, investors might be cautious about lending to riskier issuers in general, not just specific issuers. Spreads for all corporate bonds might begin to rise. Bond prices and yields move in opposite directions, so rising spreads pull down the prices of corporate bonds relative to Treasuries."

When spreads change, that may or may not have any impact on the bond issuer itself. When a company issues debt, the interest rate is usually based on the level of Treasury yields at issuance plus the risk premium investors demand.

Consider a company that issues a 7-year corporate bond. If the 7-year Treasury yield was trading at 4% and investors agreed on a spread of 3%, then the yield would be 7%. That's the company's borrowing cost, and the investors could enjoy a 7% annual return on the bond—paid in interest each year—if it remained invested in the market (companies sometimes have the ability to redeem bonds early).

However, consider what might happen if the economic outlook deteriorated after the bond was issued. Once bonds are issued, they can be traded in what's known as the secondary market. There, people will pay less or more for bonds depending on their time to maturity, the company's current prospects rather than its outlook when the bond was originally issued, or the general direction of interest rates.

Spreads might consequently rise in the secondary market. While the initial spread over Treasuries was 3%, a potential buyer in the secondary market might want a higher spread—maybe 5%—if times have become difficult and the potential buyer is worried about the company's prospects. A bondholder looking to sell the bond would likely need to sell at a lower price, reflecting the higher spread, to entice those new buyers.

If spreads remained elevated in the secondary market when it was time for a company's bond to mature, or be repaid, and the issuer decided to refinance the bond, they would likely need to issue it at the higher interest rate. This is why a higher spread can theoretically raise borrowing costs.

A sudden surge in credit spreads can be very concerning because companies generally rely on debt financing to do many things that keep them healthy. They borrow to finance research and development, build new facilities, or hire workers when product demand climbs.

"A rise in borrowing costs could result in companies scrapping existing business plans if the costs would be too prohibitive, and it can impact the ability of issuers to refinance existing debt," Martin said. "Many high-yield bond issuers already have a large debt burden, and there often isn't much margin for error to remain current on their interest expense if their earnings were to decline. So, a sudden surge in borrowing costs can make it even more difficult for highly indebted companies to stay afloat."

This is why high-yield corporate bonds can be very risky for investors, and why they offer higher yields. A higher yield might seem enticing, but if a company gets into trouble and defaults, investors generally lose money.

Over time, high-yield bonds tend to be more correlated to stocks than Treasuries, highlighting their risky nature. Investors should exercise moderation when investing in these.

If the economy is strong and the stock market is rising, credit spreads tend to fall because investors aren't too concerned with the risk of a failed repayment. As credit spreads fall, high-yield bond prices rise relative to Treasuries. Therefore, in good times, high-yield bond investors are often rewarded with higher prices and the large income payments they provide.

"That correlation cuts both ways," Martin said. "Spreads tend to rise if the outlook deteriorates, sending their prices lower. Stock prices usually fall in this scenario as well. The drop in high-yield bond prices might catch investors off guard because the price decline can happen fast. Meanwhile, U.S. Treasury prices tend to rise when the economic outlook deteriorates because investors prefer to hold assets with low perceived risks." Keep in mind that the U.S. government has never defaulted on its debt, and as a result, Treasury yields tend to be relatively low.

The lowest-rated bonds—generally those rated B or CCC—tend to be affected most from dramatic changes in the economy. They tend to have the weakest fundamentals, and their spread fluctuations can be large.

When the outlook deteriorates, their spreads can rise by hundreds of basis points. For example, in the early days of the COVID-19 pandemic, the average spread of the Bloomberg B US Corporate High-Yield Index rose by more than 800 basis points in just a few weeks, but the average spread of the A-rated index rose a little more than 200 basis points.

In that case, holders of high-yield bonds suffered as the value of their investments plunged, because bond prices fall as yields rise. This is the type of risk that holding high-yield bonds brings and can temper investor enthusiasm for the high yields they offer.

How spreads change depends on the economic environment. When the economy is healthy, spreads tend to be low, and when the outlook deteriorates, they tend to be high.

"Spreads are rarely at their average—they are usually above or below," Martin said.

Spreads have generally benefitted from periods of quantitative easing (QE) by the Federal Reserve as well. This is a strategy the Fed adopted during the financial crisis of 2007–2009 to keep yields low and encourage investment. Given the support to the economy that QE was meant to provide, risk assets like high-yield bonds benefited by seeing their average spreads decline. There could still be ups and downs during QE, but the trend was generally lower spreads.

It can be beneficial to keep an eye on the spread environment, even for investors who do not have bonds in their portfolios. Bloomberg and ICE BofA are the two most common bond index families to be aware of, and investors can monitor the spreads of these corporate bond indexes through FRED^®, the St. Louis Federal Reserve Economic Data website.