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Yield Spreads: Definition, Predictive Power, and Practical Examples

Last updated 03/19/2024 by

Silas Bamigbola

Edited by

Fact checked by

Summary:
The yield spread, often expressed in basis points or percentage points, measures the difference in yields between debt instruments with varying maturities, credit ratings, issuers, or risk levels. This essential metric influences bond investments and economic forecasts, providing insights into financial market conditions. This article explores the concept, types, and significance of yield spreads, shedding light on their role in investment decisions and economic predictions.

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Understanding yield spread

Yield spread, a fundamental concept in the world of finance, refers to the difference between yields on various debt instruments. This difference can be attributed to differences in maturity, credit ratings, issuers, or risk levels. Yield spreads are typically expressed in basis points (bps) or percentage points.

How yield spread works

Yield spread serves as a crucial metric for bond investors, helping them assess the cost associated with a particular bond or a group of bonds. By comparing the yield of one bond with another, investors can gauge the attractiveness of a particular investment. The greater the yield spread, the higher the risk that bond carries.
Investors often evaluate non-Treasury bonds in comparison to Treasury bonds of similar maturity. Treasury bonds are generally considered low-risk, offering lower yields. In contrast, bonds with higher perceived risk must provide investors with a more significant yield spread to compensate for the increased risk.
One key aspect of yield spread is its propensity to change. As bond yields fluctuate, so do yield spreads:
  • When spreads increase, the yield difference between two bonds widens, indicating one sector’s outperformance over another.
  • Conversely, narrowing spreads suggest that one sector is underperforming compared to another, as the yield difference decreases.
A practical example of this is when high-yield bond spreads widen compared to Treasury yields, indicating that high-yield bonds are underperforming Treasuries during that period.

Yield spread and economic indicators

Yield spreads are not just useful for investors; they are also valuable economic indicators. Wider spreads often lead to a positive yield curve, signifying stable future economic conditions. In contrast, when spreads contract, it may signal economic downturns, leading to a flattening of the yield curve.
This makes yield spreads an essential tool for predicting economic recessions and recoveries. They provide insights into how investors perceive economic conditions and can be a leading indicator of the economy’s health.

Yield spread vs. credit spread

While yield spread measures the difference between yields on debt instruments of varying characteristics, credit spread specifically reflects the difference between the yield on a Treasury bond and that of a corporate bond with the same maturity. U.S. Treasury bonds are often used as a benchmark due to their risk-free status.
U.S. Treasury bonds are widely considered the closest thing to a risk-free investment, backed by the full faith and credit of the U.S. government. They are almost immune to the risk of default, making them a standard benchmark for assessing credit risk in corporate bonds.

Types of yield spreads

Zero-volatility spread (Z-spread)

A zero-volatility spread, or Z-spread, measures the spread realized by an investor over the entire Treasury spot-rate curve, assuming the bond would be held until maturity. Calculating the Z-spread can be a complex and time-consuming process, involving numerous calculations based on trial and error.
Investors essentially start by trying different spread figures and running calculations to determine if the present value of the cash flows equals the bond’s price. This process continues until the two values align.

High-yield bond spread

The high-yield bond spread calculates the percentage difference in current yields between various high-yield bonds and investment-grade corporate bonds, Treasury bonds, or other benchmark bond measures. A wider high-yield bond spread compared to the historical average suggests higher credit and default risk for high-yield or junk bonds.

Option-adjusted spread (OAS)

The option-adjusted spread, or OAS, translates the difference between the fair price and market price of a bond into a yield measure. This calculation takes into account interest rate volatility and the impact of embedded options on cash flows. It’s a crucial consideration when determining the value of securities with embedded options.
Pros and Cons of Yield Spreads
Here is a list of the benefits and drawbacks to consider when dealing with yield spreads.
Pros
  • Valuable Investment Indicator: Yield spreads provide critical information for investors, helping them assess the attractiveness and risk of different debt instruments.
  • Forecasting Economic Conditions: Yield spreads are essential for predicting economic performance. Widening spreads can indicate economic growth, while narrowing spreads may suggest economic challenges.
  • Diverse Applications: Yield spreads are versatile and can be used for various purposes, including relative value analysis, economic forecasting, and credit risk assessment.
Cons
  • Complex Calculations: Calculating certain types of yield spreads, such as the zero-volatility spread, can be intricate and time-consuming, requiring multiple calculations.
  • Subject to Market Fluctuations: Yield spreads are influenced by changes in bond yields, making them susceptible to market fluctuations.
  • Risk Factors: Narrowing spreads can signal increased risk, and high-yield bond spreads wider than historical averages suggest higher credit and default risk.

Example of a yield spread

To illustrate the concept, consider two bonds issued by different companies with varying financial strengths. Typically, a bond from a larger, financially-healthy company trades at a relatively low spread compared to U.S. Treasuries. In contrast, a bond from a smaller, financially weaker company would trade at a higher spread relative to Treasuries. These differences in spreads reflect the varying risks associated with different issuers and their creditworthiness.

Additional examples of yield spread

Let’s delve deeper into some practical examples of yield spreads to illustrate how they work in various scenarios.

Example 1: Corporate bonds vs. U.S. Treasuries

Imagine you’re considering investing in two bonds, one is a corporate bond, and the other is a U.S. Treasury bond, both with a 10-year maturity. The corporate bond offers a yield of 5%, while the Treasury bond provides a yield of 2%. To calculate the yield spread, subtract the Treasury bond yield from the corporate bond yield: 5% – 2% = 3%. In this case, the yield spread is 300 basis points (bps). This indicates that the corporate bond carries a higher risk, and investors require a 3% higher yield to compensate for that risk.

Example 2: Municipal bonds and economic conditions

Yield spreads can also provide insights into local economic conditions. Consider municipal bonds issued by two different cities with the same maturity. City A’s bonds yield 3%, while City B’s bonds yield 5%. The yield spread between these two sets of bonds is 2%. If City A’s bonds typically yield more than City B’s, it could signal that City A is facing economic challenges. Investors demand a higher yield to offset the perceived risk of investing in City A’s bonds.

Yield spread strategies

Strategy 1: Relative value analysis

Investors may conduct relative value analysis by comparing yield spreads across various bonds to identify investment opportunities. If a bond’s yield spread widens compared to historical averages, it may be seen as undervalued and attractive. Conversely, if the spread narrows significantly, it may indicate overvaluation.

Strategy 2: Economic forecasting

Investors and economists use yield spreads to forecast economic conditions. For instance, a steepening yield curve, where long-term yields rise more than short-term yields, may suggest expectations of economic growth. In contrast, an inverted yield curve, where short-term yields exceed long-term yields, can be a precursor to an economic downturn.

Strategy 3: Credit risk assessment

Yield spreads also play a critical role in assessing the credit risk of different issuers. Wider spreads often indicate higher credit risk, while narrower spreads suggest lower credit risk. Investors can use this information to make informed decisions when selecting bonds for their portfolios.

Can yield spreads forecast future economic performance?

Yield spreads play a crucial role in forecasting economic performance. They are considered leading indicators that can help predict whether a recession or recovery is on the horizon. Widening spreads often indicate a positive yield curve, suggesting future economic growth. In contrast, a flattening yield curve implies a pessimistic outlook for the economy, with short-term rates expected to decline.

Yield spread premium

A yield spread premium is a form of compensation paid to mortgage brokers by lenders. Mortgage brokers receive this fee when they provide borrowers with loans that have interest rates higher than the lender’s standard rates. It’s important to note that the yield spread premium does not include other costs that borrowers are responsible for, such as commissions and fees.

The bottom line

Yield spreads are invaluable tools for savvy investors and fund managers. They provide insights into the differences between bonds with varying maturities, issuers, credit ratings, and risks. By understanding yield spreads, investors can make informed decisions about their investments.

Frequently asked questions

What is a yield spread?

A yield spread measures the difference in yields between different debt instruments with varying characteristics, such as maturities, issuers, credit ratings, or risk levels.

How do yield spreads work?

Yield spreads work by subtracting the yield of one debt instrument from another, usually in terms of basis points or percentage points. They provide insights into the attractiveness and risk associated with investments.

Can yield spreads predict economic performance?

Yes, yield spreads are often used as leading indicators to predict economic performance. Widening spreads can indicate economic growth, while a flattening yield curve may suggest economic challenges ahead.

Key takeaways

  • Yield spread measures the difference in yields between debt instruments with varying characteristics.
  • Wider yield spreads often indicate positive economic conditions, while narrowing spreads may suggest economic challenges.
  • There are different types of yield spreads, including Z-spread, high-yield bond spread, and option-adjusted spread.

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