What it means
The most common everyday use is the bid-ask spread, the gap between the highest price a buyer will pay and the lowest a seller will accept. It is a real cost of trading, because anyone who buys and immediately sells loses the spread even if the market has not moved at all.
The second major use is the credit spread, the extra yield a borrower pays above a government bond of the same maturity. That premium is the market's price for the chance of not being repaid, so it widens when a company weakens and narrows when confidence returns.
Banking uses the term for the difference between what a bank earns on loans and what it pays on deposits, which is the core of how a lender makes money. A bank charging 7% on mortgages and paying 2% on savings is earning a spread of five percentage points before costs and bad debts.
Spreads are usually quoted in basis points, where one basis point is one hundredth of a percentage point, so a spread of 290 basis points means 2.9%. That convention exists because small differences matter enormously when they apply to very large balances.
In derivatives and commodity trading, a spread is a position in two related contracts rather than a single price difference. A trader long crude oil and short petrol futures is trading the spread between them, hoping the relationship changes even if both prices move together.
The practical lesson for anyone reading a report is to ask what the two numbers are before interpreting the figure. A widening spread can be good news, bad news or simply a technical shift depending entirely on which comparison is being described.
In practice
Real-world examples
Example 1
A treasurer comparing two banks' loan offers finds both quoted as a benchmark rate plus a margin, one at 175 basis points and the other at 210. On a $25 million facility the 35 basis point difference is worth $87,500 a year, which more than covers the cost of switching lenders.
Example 2
A fund manager notices the bid-ask spread on a small cap holding has widened from 0.5% to 3% during a market panic. The position is nominally worth $4 million, but selling it quickly would cost far more than the screen price suggests, so the manager sells a liquid holding instead.
Example 3
A corporate finance team watches the credit spread on its own bonds widen by 90 basis points over a quarter with no news from the company. The move reflects a general repricing of the sector, but it still tells the board that a planned refinancing next year will be more expensive than budgeted.
Think of it
Spread is the gap between two rates-the difference between yields.
Formula
Calculation
Bid-ask spread = ask price - bid price
Credit spread = corporate bond yield - government bond yield of the same maturity
A mid cap share is quoted at $49.90 bid and $50.10 ask. The bid-ask spread is $50.10 - $49.90 = $0.20, and against a midpoint of $50.00 that is $0.20 / $50.00 = 0.4% of the price. An investor buying 20,000 shares at the ask and selling them straight back at the bid pays 20,000 x $0.20 = $4,000 for the round trip before any commission.
Now the credit version. A manufacturer issues a ten-year bond yielding 7.2% while the ten-year government bond yields 4.3%, so the credit spread is 7.2% - 4.3% = 2.9%, or 290 basis points. On a $10,000,000 issue, that premium costs the company $10,000,000 x 0.029 = $290,000 a year more than a risk free borrower would pay.
If the company is later upgraded and its spread narrows to 180 basis points, refinancing the same $10,000,000 would cost $10,000,000 x 0.018 = $180,000 a year, an annual saving of $290,000 - $180,000 = $110,000.Case study
Seen in the real world
The following is an illustrative and entirely fictional example. Trellis Home Furnishings, an invented retailer, borrowed $60 million on a five-year facility priced at a benchmark rate plus 200 basis points, with a clause that widened the margin to 375 basis points if the ratio of debt to earnings passed three times. Nobody in the finance team had modelled what that clause would cost.
A weak Christmas pushed the ratio to 3.2 times, and the margin stepped up automatically at the next reset. The additional 175 basis points on $60 million added $60,000,000 x 0.0175 = $1,050,000 to annual interest, at precisely the moment the business could least afford it.
The fictional finance director's later summary was blunt: the covenant did not simply measure distress, it deepened it. When the facility was refinanced the team negotiated a smaller step-up and a cure period, accepting a slightly higher opening spread in exchange.
Watch out
Common mistakes
- Using the word without saying which two numbers are being compared, so that a credit spread, a bid-ask spread and a trading spread get discussed as if they were the same thing.
- Ignoring the bid-ask spread when calculating returns on frequently traded positions, where it can quietly consume more than the strategy earns.
- Confusing basis points with percentage points and reading a 290 basis point spread as 290%, an error that is embarrassing rather than expensive but happens often.
Questions
People also ask
Why do bid-ask spreads widen in a crisis?
Because market makers face greater risk of being caught with an unwanted position, so they demand more compensation for quoting prices at all.
Does a narrowing credit spread always mean a company is improving?
Not necessarily; spreads can tighten across a whole market when investors have surplus cash to invest, regardless of any single borrower's position.
How is a spread different from a margin?
In lending they are used almost interchangeably for the premium above a benchmark, though margin more often refers to the contractual number written into a loan agreement.