One of the most commonly used measures of credit spread is the traditional credit spread, which is the difference between the yield to maturity, the YTM of a corporate bond and the YTM of a government bond with a similar maturity.

Let's walk through an example here.

We have a Deutsche Telecom corporate bond with a YTM of 2.432%, and a maturity date of January 17th, 2028.

We want to compare this with a German government bond that has the closest possible maturity.

In this case, we have two options.

And October, 2027 bond with a YTM of 1.089%, and an August, 2028 bond with a YTM of 1.108% Since October, 2027, is closer to the corporate bonds maturity date.

We choose it as the benchmark.

To calculate the traditional credit spread, we simply subtract the government bonds yield from the corporate bonds yield.

In this case, that would be 2.432% minus 1.089%, which equals 1.343%.

So one of the advantages of the traditional credit spread is that it is relatively simple to calculate, but it can also be traded directly.

If an investor expects, for example, the credit spread to decline or to narrow or tighten, but wants to avoid interest rate risk, they could buy the corporate bond and short sell the October, 2027 government bond.

This position would benefit if the corporate bond's price increases relative to the government bond, meaning the corporate yield falls, and the spread tightens.

However, there's a potential limitation with the traditional spread.

It does not always account for differences in maturity perfectly.

In this example, the yield curve is almost flat, since both government bonds have nearly the same yield, making the impact of the slight maturity difference minimal.

However, imagine if the yield curve were much steeper with the August, 2028 bond trading at say 2.108% due to the longer maturity.

In that case, using a traditional spread might not accurately reflect the credit risk as it would overlook the impact of the steep yield curve.

Let's unpack this a bit further.

In a steep yield curve environment yields increase substantially with each additional year to maturity.

If we use a government bond with even a slightly longer maturity as the benchmark part of the yield difference could be due to this extra term, not purely the corporate credit risk.

So while the spread might suggest that the corporate bond has a higher credit risk, it's actually capturing some of the yield curve effect from the longer government bond.

As a result, the traditional spread may appear wider than it truly is in terms of pure credit risk, potentially giving investors a misleading impression of the corporate bonds risk profile.