Credit Spread Essentials: Investing and Borrowing Strategy Insights

Companies and governments raise money by issuing bonds. A bond works just like a loan for these large organizations. Each bond is for a set period. It pays interest during this time before the issuer returns the money to the investor who lent it.

For example, you might buy a 10-year bond for $10,000, paying 5% a year. Every year, you collect $500 of interest. At the end of the ten years, you should get your $10,000 back.

That’s how a bond works if everything goes properly. However, large companies and even countries can run into financial trouble.

If a bond issuer doesn’t have enough money, it might miss interest payments to bondholders. In a worst-case scenario, an organization could go bankrupt. You might not get your money back if you own one of its bonds.¹

Each bond issuer has a different level of risk based on its financial situation. The U.S. federal government is considered the safest borrower. It has never defaulted and always made its debt interest payments.²

For this reason, the U.S. can often pay the lowest interest rate on the market for its bonds. This is called the “risk-free” rate.³

Credit spread over the risk-free rate

Every other company and organization must pay a higher interest rate than the risk-free rate to compensate for the higher chance they won’t pay back the money. Otherwise, investors will just buy risk-free U.S. bonds.

The credit spread measures this difference for bonds of similar length. For example, let’s say the U.S. is paying 4% on its 10-year bond, while a large corporation is paying 5% for its 10-year bond. The credit spread is 1%.⁴

Like individuals, companies with a better credit record and more financial resources are charged lower interest rates to borrow.

So why do credit spreads matter to you as an investor? There are a few ways you can put this information to good use.

• Investment returns and risk: Investing is a tradeoff between risk and reward. If you buy bonds with a high credit spread, you’ll earn more interest each year. However, there’s a greater chance you won’t get your money back. You need to decide whether the extra income is worth the risk.
• Stock research: Credit spreads can give you more information about a company’s financial position before buying its stock. If a company has a higher bond spread than similar competitors, it shows that investors feel the company may have more financial issues. You might have a higher chance of losing money buying its stock and its bonds.⁴
• More up-to-date information: Credit rating agencies give companies a letter score based on their financial strength. For example, AAA is the best rating. Scores BBB and below indicate more potential financial problems.⁵
• Economic trends: Credit spreads also provide information about the overall economy. If the credit spread widens, companies suddenly need to pay more than the risk-free rate to borrow. This could happen when investors are concerned about a market crash and move their money to safety with the U.S. government. On the other hand, when investors feel good about the economy, credit spreads tighten. The gap between their bonds and the risk-free rate falls. You can use this information to plan your long-term investment decisions.⁴

As an individual, you aren’t issuing bonds to raise money. However, the same general concept applies to mortgages, car loans, credit cards, and personal loans.

The safer someone seems to a lender, the lower the interest rate they’ll be charged. Lenders decide based on your credit score, income, and other outstanding debts.

Here’s a rough range of interest rate spreads for different types of loans:

• 30-year mortgages: 6.63% to 8.23%⁶
• New car loans: 5.64% to 21.55%⁷
• Credit cards: 12.7% to 21.1%⁸

The cost of interest

Even the safest individual borrowers still pay higher interest rates than the government and large corporations. However, qualifying for lower rates can make a major difference to your bottom line.

For example, let’s say you take out a $300,000 home loan. If you qualify for the 6.63% 3-year rate, your monthly payment would be roughly $1,924. On the other hand, if you only qualify for the 8.23% rate, your monthly payment would be $2,249, more than $300 a month higher.

A better credit score can reduce your credit spread and help you qualify for lower interest rates when you borrow. Here’s how you can improve your score.

• Use a secured card to get started: You usually need a good credit score and established history to qualify for most loans and credit cards. If you’re new to credit or had financial trouble in the past, you can start with a secured credit card. With this type of card, you put down a cash deposit and use the card for regular purchases. Pay your bill every month, and your credit score will improve. Soon enough, you can qualify for a regular credit card that doesn’t require a deposit.
• Always pay bills on time: On-time payments are one of the most important factors for your credit score. Whether it’s credit cards, student loans, a car loan, or a mortgage, aim to always make your monthly payment on time.
• Avoid carrying a credit card balance: Lenders look at how close you are to maxing out your credit cards. The lower your balances, the better your credit score. Try to pay off spending in full each month.
• Check your credit report for mistakes: Even credit bureaus make mistakes. You can request free credit report copies every year to review your records. Check for issues, like the report showing an unpaid loan you never took out. If you find a mistake, call the agencies to fix the error.
• Plan ahead for large loan applications: If you’re getting ready to apply for a mortgage or car loan, every credit score point counts for your interest rate. In the months before you apply for a significant loan, avoid applying for credit cards and other small personal loans

There is no such thing as free money, even for the U.S. government. When people, companies, and organizations borrow, they must pay interest. The credit spread shows just how much they need to pay to borrow cash.

You can use this concept to make better investment decisions and to qualify for lower interest rates in your own life. While you might not reach the same “risk-free” rate as the U.S. government, you can get closer by properly managing your credit score.