Credit spreads: what they are and why they warn before equities

What a spread actually is

When the US Treasury borrows for ten years it pays a certain yield. When a company borrows at the same maturity it always pays more, because a government issuing in its own currency rarely defaults and a company can. That difference is the credit spread, and it is expressed in basis points: 100 basis points equal 1%.

The figure people track is the OAS, or option-adjusted spread. Many corporate bonds include clauses letting the issuer redeem them early, and that option has value. The OAS strips that effect out to leave only what compensates default risk, which is what you want to compare across periods.

High yield and investment grade

Rating agencies split corporate debt into two large blocks. Investment grade covers the soundest companies, rated BBB− or above. High yield — once called junk debt — gathers the lower-quality issuers, which pay more precisely because their default risk is higher.

High yield is the one that matters as a thermometer. Its issuers are leveraged, cycle-sensitive companies, so they react before anyone else when the economy cools. Investment grade moves less and later: when it widens too, the worry has stopped being sectoral and turned systemic.

The levels that matter

In high yield, a spread below 300 basis points indicates a calm market with appetite for risk. Between 300 and 500 is the normal range. Above 500 there is genuine concern, and above 800 the market is pricing a wave of defaults. At the peak of the 2008 financial crisis the spread topped 2,000 basis points, and in March 2020 it went past 1,000.

In investment grade the scale is far tighter: below 100 basis points the market is relaxed, and going past 200 is already a serious signal. In 2008 it came close to 600.

More than the level, what Semavor watches is speed. A spread widening abnormally versus its own behaviour over the past year fires a credit stress signal even if the absolute level is still low. The change matters more than the starting point.

Why they warn before equities

Whoever buys corporate debt is not hoping the company does brilliantly: they just need it to pay. Their analysis centres on solvency and debt-servicing capacity, not growth expectations. That makes the credit market a colder observer, less prone to euphoria than the equity market.

Historically spreads began widening weeks or months before equities reacted, in both 2007 and 2000. When stocks rise and credit spreads widen at the same time, that divergence is one of the most useful signals there is: two markets are reading the same reality in opposite ways, and credit usually gets it right.