What Is Yield Spread?
The yield spread is the difference in yield between two different bonds. Investors use the yield spread to measure the relative value of two different securities, particularly as it pertains to credit quality but also to liquidity and supply, which can influence bond prices and yields. Yield spread is measured in basis points.
Most commonly, yield spread is measured against a benchmark, usually the yield on U.S. Treasury securities with a similar maturity date. Treasury securities are considered to be "risk free" because of their unlikelihood to default, while most other bonds have some degree of default risk. Generally speaking, the lower a bond issuer's credit rating, the greater the yield spread against comparable Treasuries or other bonds with a similar maturity. That's because investors expect a higher yield for taking on more risk.
Wide And Narrow Yield Spreads
Yield spreads widen and narrow constantly in the market as investors and traders change their perception of a bond's relative risk and supply in the market. For example, investors in corporate bonds measure the difference in yield between a 10-year corporate bond and a 10-year Treasury bond in order to determine if the former is being underpriced by the market, which would indicate it is of good value. A wider yield spread might indicate that the corporation's credit is slipping, while a narrower spread might show an improvement.
Yield spreads are also used to measure two similar bonds with the same credit rating and maturity. If one bond is yielding significantly more than the other, it may indicate that its credit is worsening or that there is relatively too much supply of that company's bonds outstanding versus a competitor. It could also indicate a relative bargain.
Treasury And Corporate Bond Markets
In the Treasury market, investors analyze spreads between different maturities. The spread between two-year and 10-year Treasuries, for example, is a popular yield spread to watch, although investors look at other spreads within the yield curve. In a normal market, long-term bonds yield more than short-term bonds, because investors expect a higher return for locking up their money for longer. But occasionally the spread between the long end and the short end narrows or even inverts, which may indicate investor perception of lower long-term inflation.
In the corporate bond market, investors often focus on the spread between highly-rated "investment grade" and lower-rated "junk" bonds, with the former almost always yielding less than the latter. If the yield spread between the two markets widens, that may indicate that investors are worried that lower-rated companies may have a harder time meeting their debt obligations. Narrower spreads may indicate greater demand for bonds that have higher yields.
The yield spread measures the relative value of one bond versus another, particularly as it pertains to credit quality as well as liquidity and supply. Generally speaking, the higher the yield, the greater the risk. Yield spread is measured in basis points.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…