Lesson 3 of 25 · 7 min

What a spread widening actually is

Two things move it: the chance of loss, and the price of bearing that chance. The second is larger.

A credit spread is not a forecast of default. It is a payment for three separate things bundled into one number, and treating the whole of it as a default forecast makes every widening look like a prediction of disaster.

spread = expected loss + risk premium + balance-sheet cost

spread: The yield a borrower pays above a comparable risk-free reference, quoted in basis points.
expected loss: Probability of default multiplied by the fraction not recovered. Usually the smallest of the three.
risk premium: Payment for bearing the uncertainty around that estimate, rather than for the estimate itself.
balance-sheet cost: What it costs the holder to finance the position and hold capital against it, plus compensation for illiquidity.

Put illustrative numbers on it. A 210 basis point spread on a bond with a 0.35 percent annual default probability and a 42 percent recovery contains 0.35 percent times 58 percent, which is 20.3 basis points of expected loss. The other 190 points are the price of risk and the cost of holding the thing. When that spread goes to 350, almost none of the 140 point move needs to be a change in the default estimate. The cash flows can be identical and the price of bearing them different.

Now land it on collateral, because a spread widening is a price move in everything you hold that has a spread. A bond fund holding with a duration of 4.3 years, hit by a 140 basis point widening, falls by roughly 4.3 times 1.40 percent, which is 6.02 percent. On an $880,000 holding that is $52,976 of market value, and at an 80 percent advance rate it is $42,380.80 of lending value, from $704,000 down to $661,619.20.

Nothing defaulted. No rating moved. The reason the collateral is worth less is that other people now require more compensation to hold the same promises, and a mark is taken from the price other people will pay.

Key terms

Credit spread: The extra yield a borrower's debt pays over a risk-free reference. Distinct from the spread on a line of credit, which is a lender's margin.
Expected loss: Default probability multiplied by the share of value not recovered. Typically a small fraction of the spread that is paid.
Price of risk: What the market charges for bearing uncertainty as distinct from the uncertainty itself. It moves far more than the underlying estimates do.
Duration: The approximate percentage a bond price falls for each one percent rise in its yield. It converts a spread move into a price move.

Worked example

Decomposing 210 basis points, then repricing a holding

Illustrative figures. A bond holding of $880,000 at an 80 percent advance rate, duration 4.3, default probability 0.35 percent, recovery 42 percent.

Expected loss inside the spread: 20.3 bp
Everything else inside the spread: 189.7 bp
Price fall on a 140 bp widening: 6.02%
Market value after: $827,024
Lending value before and after: $704,000 to $661,619.20
Lending value lost: $42,380.80

A move in the price of risk, with no change in any credit estimate, removed forty-two thousand dollars of borrowing capacity from a holding that paid every coupon on time.

Check yourself

You hold $640,000 of a bond fund with a duration of 6.1 at a 78 percent advance rate. Spreads widen by 95 basis points and nothing in the fund defaults. What happens to its lending value?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.