Mastering Credit Spreads: A Low-Risk Options Trading Strategy

What is a Credit Spread?

A credit spread, also known as "the spread," is the difference in yield (return) between two debt instruments with the same maturity but different credit ratings. It reflects the additional risk that investors take on when lending to a borrower with a lower credit rating compared to a risk-free benchmark rate, typically a U.S. Treasury bond of the same maturity.

Credit spreads indicate the market's perception of the creditworthiness of corporate borrowers. A wider credit spread suggests that the market sees the borrower as having a higher risk of default, while a narrower spread indicates a lower perceived risk.

Same maturity refers to the same time to maturity for both debt instruments being compared. This ensures that the credit spread reflects only the difference in credit quality, not differences in the term of the debt. Common debt instruments used to calculate credit spreads include corporate bonds and treasury notes.

Key Takeaways:

• Credit spreads measure the yield difference between corporate bonds and risk-free benchmarks, reflecting the additional risk associated with corporate debt, and can also refer to an options trading strategy that helps manage risk.
• When evaluating credit spreads, investors must balance the advantages of reduced risk and limited maximum loss against the disadvantage of capped profit potential compared to selling uncovered options.
• Understanding how to assess and trade credit spreads is essential for managing risk and optimizing returns in portfolios, especially in navigating the complex market conditions expected in 2024 and beyond.

Formula for Credit Spread

To calculate the credit spread, investors use a formula that takes the difference between the yield to maturity (YTM) of a corporate bond and the benchmark rate, typically represented by a risk-free government bond:

Credit Spread (%) = Bond Yield - Benchmark Rate

The benchmark rate, as stated earlier, is most often the yield on a U.S. Treasury bond of the same maturity as the corporate bond being evaluated.

Example of Credit Spread Calculation

Suppose a corporate borrower is raising capital via a bond issuance in 2024. The borrowing term of the bond is ten years, and a potential investor is anticipated to hold the bond until maturity. The benchmark rate of a 10-year Treasury note is 4.00%. If the estimated yield to maturity (YTM) of the corporate bond is 6.0%, the credit spread would be calculated as follows:

Credit Spread = 6.0% - 4.00% = 2.0%

In this example, the credit spread of 2.0% represents the additional yield that investors demand to compensate for the higher risk of the corporate bond compared to yields on the risk-free Treasury note.

Types of Credit Spreads

Credit spreads can also refer to a type of options trading strategy involving the simultaneous purchase and sale of options contracts. The two main types of credit spreads are credit put spreads and credit call spreads.

Credit Put Spreads

How Credit Put Spreads Work

A credit put spread can be used in place of an outright sale of uncovered put options. Credit spreads are an options trading strategy that involves concurrently buying and selling options of the same type (either puts or calls) on the same underlying asset, but with different strike prices.

A credit put spread involves selling a put option with a relatively higher strike price while concurrently purchasing another put option on the same underlying asset with a lower strike price. The premium you pay for the option purchased is lower than the premium you receive from the option sold, resulting in a net credit to your account.

Credit Put Spread Example

Suppose XYZ stock is trading at $75. You sell 8 XYZ puts with a $75 strike price for $2.50 per contract and buy 8 XYZ puts with a $70 strike for $0.75 per contract. The credit put spread is established by collecting a net credit of $1,400, which is calculated as the difference between the premium received from selling 8 contracts (2.50 points per contract) and the premium paid for purchasing 8 contracts (0.75 points per contract), with each contract representing 100 shares.

You will profit if the market price of XYZ closes above $73.25 at expiration. If the price of XYZ falls below the breakeven point of $73.25, you will incur losses, with the maximum potential loss capped at $2,600 if XYZ closes at or below $70 when the options expire.

Credit Call Spreads

How Credit Call Spreads Work

A credit call spread can be used in place of an outright sale of uncovered call options. The mechanics of a credit call spread (a type of vertical spread) are virtually the same as those of a credit put spread.

Constructing a credit call spread entails selling a call option with a comparatively lower strike price and simultaneously buying a call option on the same underlying security with a higher strike price. Again, the premium received from the option sold is higher than the premium paid for the option purchased, resulting in a net credit.

Credit Call Spread Example

Imagine XYZ stock is currently priced at $68. You sell 6 XYZ call options with a strike price of $68, earning $3.00 per contract, and simultaneously purchase 6 XYZ call options with a $74 strike price, costing $1.00 per contract. This results in a net credit of $1,200 (3.00 points premium received - 1.00 points premium paid x 6 contracts) with each contract representing 100 shares.

You will achieve a profit if XYZ's market price is below $71.00 at expiration. However, you will incur a loss if the price exceeds $71.00, with the maximum possible loss being $2,400 if XYZ closes at $74 or higher at expiration.

Credit Spread Strategies

Reducing Risk with Credit Spreads

Credit spreads are an options strategy where you simultaneously buy and sell options on securities that are of the same class (puts or calls) on the same underlying security. They can be a helpful risk-management tool for reducing risk substantially by forgoing a limited amount of profit potential.

A significant benefit of credit spreads is the ability to determine the precise level of risk when initiating the trade. The maximum potential loss is capped at the difference between the strike prices of the options, minus the net credit received, providing a clear understanding of the trade's risk profile.

Corporate Bond Credit Spread Calculation Example

To further illustrate how credit spreads work in the context of corporate bonds, let's revisit our earlier example. Suppose a corporate borrower is raising capital via a bond issuance in 2024. The borrowing term of the bond is ten years, and a potential investor is anticipated to hold the bond until maturity.

The benchmark rate of a 10-year Treasury note is 4.00%. If the estimated yield to maturity (YTM) of the corporate bond is 6.0%, the credit spread would be 2.0% (6.0% - 4.00%).

Impact of Same Maturity Corporate Bond Yield

The credit spread of 2.0% represents the "excess" return on the corporate bond above the benchmark rate. Appreciating the concept of credit spread is essential for investors to assess whether the anticipated yield on a corporate bond investment adequately compensates for the additional risk taken on, compared to the yield offered by a risk-free security.

In this case, investors and lenders must decide if the additional 2.0% yield is enough to compensate for the higher default risk of the corporate bond compared to the Treasury note. If the market perceives that the risk is too high relative to the spread, the price of the corporate bond may fall, causing the yield to rise and the spread to widen until it reaches a level that attracts investors.

Evaluating Credit Spreads

Advantages of Credit Spreads

Credit spreads have both advantages and disadvantages compared to selling uncovered options. As mentioned earlier, one of the main advantages is that credit spreads can significantly reduce risk by limiting potential losses.

Another advantage is that you can precisely calculate your maximum potential loss when entering the trade. This is because your loss is limited to the difference between the strike prices minus the net credit received, no matter how far the underlying stock index or bond price moves.

Disadvantages of Credit Spreads

The main disadvantage of credit spreads is that they limit your profit potential in exchange for reduced risk. In our earlier credit and debit spread using examples, the maximum profit was limited to the net credit received ($1,500), while the maximum loss was capped at $3,500.

Compare this scenario to selling uncovered options, where your profit potential is theoretically unlimited (although realistically limited by the price of the underlying asset), while your loss potential is also much higher.

Essentially, the trade-off for reduced risk is a ceiling on your potential profits risk averse. Investors must weigh this limitation against the benefit of knowing exactly how much they could potentially lose on the trade.

Looking Ahead: Credit Spreads in 2024

Looking ahead to credit spreads in 2024, there are several factors that could impact their direction. Increasing optimism in markets regarding interest rate cuts and economic resilience could further compress spreads in the coming year.

If investment grade corporate spreads remain rangebound, investors can expect to gain a return advantage over Treasuries of about 1% over the course of the year. A tightening of spreads to post-Global Financial Crisis levels could generate outperformance of 1% in addition to yield, while a tightening beyond that could generate 2-3% outperformance.

However, active management will be crucial for navigating scenarios where spreads widen, such as a growth scare or hard landing, and for capturing specific opportunities. Investors should closely monitor economic conditions, market sentiment, government, and company-specific factors that could impact credit spreads in the coming year.

Ultimately, understanding how to evaluate and trade credit spreads can be a valuable tool for investors seeking to manage risk and optimize returns in their portfolios. By carefully weighing the advantages, risks and disadvantages of these strategies and staying attuned to market conditions, investors can effectively navigate the complex world of credit spreads in 2024 and beyond.