Credit spreads are one of the most reliable early warning indicators in financial markets. They often signal trouble before stock prices start declining, giving traders valuable lead time to reduce risk. In this guide, we will explain what credit spreads are, why they matter, and how to use them in your trading.
What are Credit Spreads?
A credit spread is the difference in yield between a corporate bond and a comparable Treasury bond. Since Treasuries are considered risk-free, this spread represents the extra yield investors demand to compensate for the risk that a company might default on its debt.
Key concept: When investors are confident about the economy and corporate health, they accept lower credit spreads. When they are worried, they demand higher spreads. Rising credit spreads signal increasing concern about corporate defaults and economic health.
Types of Credit Spreads
High Yield (Junk Bond) Spreads
The spread between below-investment-grade corporate bonds (rated BB or lower) and Treasuries. These spreads are more volatile and sensitive to economic conditions because these companies are more likely to default during downturns.
Investment Grade Spreads
The spread between high-quality corporate bonds (rated BBB and above) and Treasuries. These spreads are less volatile but still provide valuable signals about market stress.
Example: Credit Spread Levels
Typical high yield spread ranges:
- Tight (low risk): 3-4% above Treasuries
- Normal: 4-5% above Treasuries
- Elevated: 5-7% above Treasuries
- Crisis levels: 8%+ above Treasuries (2008 hit 20%+)
Why Credit Spreads Lead Stocks
Credit markets often price in risk before equity markets for several reasons:
- Institutional focus: Bond investors tend to be more risk-aware and act faster
- Leverage sensitivity: Companies with debt problems show up in bond prices first
- Liquidity concerns: Bond markets can signal funding stress before it hits stocks
- Default risk pricing: Bond investors directly price bankruptcy risk
Historical pattern: In both 2007 and 2020, credit spreads started widening months before stock indices peaked. Traders who watched credit markets had advance warning to reduce risk.
How to Monitor Credit Spreads
ETF-Based Monitoring
The easiest way to track credit spreads is through ETF prices and ratios:
- HYG: iShares High Yield Corporate Bond ETF
- JNK: SPDR High Yield Bond ETF
- LQD: iShares Investment Grade Corporate Bond ETF
- TLT: iShares 20+ Year Treasury Bond ETF
Example: Using HYG/TLT Ratio
Track the ratio of HYG to TLT:
- Ratio rising: Spreads tightening (risk-on, bullish)
- Ratio falling: Spreads widening (risk-off, bearish)
- Sharp drops in the ratio often precede stock weakness
Direct Spread Monitoring
For more precise tracking, monitor actual spread indices:
- ICE BofA High Yield Index: Benchmark for junk bond spreads
- CDX High Yield Index: Credit default swap index for high yield
- Investment Grade CDX: Credit default swap index for IG bonds
Trading Signals from Credit Spreads
1. Spread Widening (Bearish)
When credit spreads widen (increase), it signals growing concern about corporate credit risk. Consider these responses:
- Reduce equity exposure, especially in leveraged companies
- Avoid high-yield bond investments
- Favor quality stocks with strong balance sheets
- Consider increasing cash allocation
2. Spread Tightening (Bullish)
When credit spreads tighten (decrease), it signals improving confidence in corporate creditworthiness:
- Risk-on positioning may be appropriate
- Cyclical and higher-beta stocks often outperform
- High-yield bonds offer attractive risk-adjusted returns
- Leveraged companies can benefit from cheap financing
3. Divergence Signals
Watch for divergences between credit spreads and stocks:
Example: Bearish Divergence
The S&P 500 makes a new high, but:
- High yield spreads are widening (HYG underperforming)
- This suggests credit markets do not confirm the rally
- The stock rally may be on borrowed time
- Consider taking profits or hedging
Sector Implications
Different sectors have varying sensitivity to credit spread changes:
- Financials: Banks profit from credit intermediation, so tight spreads help
- REITs: Highly leveraged, very sensitive to credit conditions
- Utilities: Less sensitive due to stable cash flows
- Energy: High-yield energy bonds can signal stress in the sector
- Small caps: More leveraged on average, sensitive to credit conditions
Pro tip: When credit spreads widen, small-cap stocks (IWM) typically underperform large-caps (SPY). This is because smaller companies often have weaker balance sheets and less access to credit markets.
Credit Spreads in Market Cycles
Early Recovery
Spreads have peaked and begin tightening rapidly as default fears fade. This is often the best time to buy high-yield bonds and beaten-down equities.
Mid Cycle
Spreads are stable at relatively tight levels. Risk assets perform well, and volatility is low.
Late Cycle
Spreads begin widening from their lows as some companies show stress. This is a warning to reduce risk.
Recession
Spreads spike dramatically as defaults rise and liquidity dries up. This creates eventual buying opportunities for contrarian investors.
Practical Monitoring Routine
- Daily: Check HYG and JNK performance relative to TLT
- Weekly: Review high-yield spread levels and direction
- Look for divergences: Are spreads confirming or contradicting stock moves?
- Monitor extremes: Spreads at historic tights may signal complacency; spreads at historic wides may signal opportunity
Track Credit Market Signals
Pro Trader Dashboard helps you monitor risk indicators including credit market conditions, so you can stay ahead of potential market stress.
Summary
Credit spreads are an essential indicator for any serious trader. They often provide early warning of market stress before stocks react, giving you time to adjust your positioning. Monitor high-yield spreads through ETFs like HYG and JNK, watch for divergences with stock prices, and use credit market signals to improve your risk management. The credit market may not get the headlines, but it often tells the truth before anyone else.
Learn more about market indicators in our guides on yield curve trading signals and bond and stock correlations.