Lately we've been hearing that credit spreads are tightening. What are they, and why do they matter?
A spread measures how much more a business pays to borrow money than the government does.
At any given time, different companies pay different spreads for their debt, depending on factors including the maturity of the debt and the health of the company. But overall, spreads have shrunk in recent years.
It was 1.4 percentage points at the end of June, a fraction of its peak of eight percentage points in December 2008.Consider a BofA Merrill Lynch index that measures the interest rates paid by companies whose debt is rated BBB—neither the highest nor lowest quality. The weighted average spread for all the debt in the index is around its lowest level since the financial crisis, notes Jeremy Hill, managing partner at New York-based research firm Old Blackheath Cos.
Mr. Hill says tighter spreads are a result of the extraordinary efforts by central banks around the world to encourage economic growth by keeping borrowing costs low for companies and individuals. "Monetary policy is vastly different than it was 10 years ago," he says.
For investors, the lower spreads mean less of a reward for venturing into corporate debt rather than buying safer Treasurys. But, Mr. Hill notes, that hasn't stemmed demand for corporate bonds, because "investors are yield-hungry."
He adds that the credit risk of buying corporate debt has declined, in part because the lower cost of borrowing means there is less risk of companies failing to pay the interest owed.