A credit spread (also called a yield spread) is a spread between two securities that are almost identical, except for the quality rating. Because Treasuries are considered practically risk-free, they constitute a benchmark to which other bonds are compared. Thus, credit spread usually shows a spread between Treasury securities and identical (except rating) non-Treasuries. In other words, credit spread indicates the risk premium for investing in one (risky) security over another (considered to have almost no risk). For example, private companies can default, so they must offer a higher return on their bonds, because their credit rating is worse than that of the U.S. government, which, allegedly, cannot go bankrupt.
When credit risk rises, for example due to a financial crisis, investors tend to flee from the risky assets and park their money in relatively safe securities, like the U.S. treasuries, so credit spreads widens. Conversely, in quiet times investors are less risk-averse and more eagerly invest in more risky securities, compressing the credit spreads.
Credit spreads and gold
Credit spreads are indicators of economic confidence. When the credit spreads widen, the situation is bullish for gold, since there is more perceived risk in the economy. Conversely, when credit spreads tighten, the situation is bearish for gold as investors are less afraid and are consequently reducing their demand for safe-haven assets (such as gold).
The chart below shows the relationship between the price of gold and the credit spread between bonds that are below investment grade (those rated BB or below) and Treasuries.
Chart 1: The BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread (green line, left axis, in percent) and the price of gold (yellow line, right axis, P.M. London Fixing)
As one can see, a rise in credit spreads between 2007 and 2009 proved to be bullish for gold, while the narrowing of credit spreads between 2011 and 2014 was accompanied by a decline in the price of gold.
However, the correlation is not perfect (credit spreads were tightened between 2003 and 2007, while the shiny metal enjoyed a bull market). It means that credit spreads alone, though a theoretically important factor in the gold market, cannot fully explain the dynamics of the price of gold. Investors should also pay attention to other factors, such as real interest rates and the U.S. dollar exchange rate.
We encourage you to learn more about gold – not only how to use it as insurance against the credit risk, but also how to successfully apply gold as an investment and how to profitably trade it. Great way to start is to sign up for ourtoday. It's free and if you don't like it, you can easily unsubscribe.Back