A Credit Spread is a way for investors to make money by betting on the price movements of a credit risk. A credit spread is the difference in yield between a U.S. Treasury bond and another debt security of the same maturity but different credit quality. For example, suppose an investor bought a five-year U.S. Treasury bond paying 1.40 percent interest with $100 she had on hand. At the same time, she also bought a ten-year U.S. Treasury bond paying 3 percent interest with $100 she had on hand. The investor’s total cost for her two securities was $1,400—$100 in each security plus her broker’s commissions of about $12 for buying and selling each security. The yield to maturity for each security is also known as the coupons or cash flow rate, since it’s what the holder receives when she sells the security at maturity.A credit spread usually increases in value when the spread’s underlying asset’s price drops because investors will pay more for an asset that yields more than their money; they are effectively earning interest on their investment as long as they hold it until its price rises enough to cover their cost of funds (i. 16). A financial firm that uses this strategy typically has short positions in various securities that it uses to create credit spreads; these securities tend to drop in value once it hashed out its positions using these strategies (the investor will have made more money if she had simply invested her money instead of trying to make money by gambling with other people’s money). To hedge her bets correctly, an investor must set up a position—usually through an OTC derivative contract—that corresponds with every transaction she makes using these strategies (if you don’t know what an OTC derivative is or how they work, see Appendix B).
