What is a High-Yield Bond Spread?
A high-yield bond spread refers to the percentage difference between the yields of high-yield bonds and benchmark bond measures, such as investment-grade corporate bonds or Treasury bonds. Expressed in percentage points or basis points, this spread is also known as the credit spread.
Key Takeaways
- The high-yield bond spread, or credit spread, is the yield difference between high-yield bonds and benchmark bonds like investment-grade or Treasury bonds.
- These bonds offer higher yields due to the increased default risk, meaning the higher the risk, the higher the interest returns.
- High-yield bond spreads serve as indicators of credit market conditions; widening spreads often signal weakening macroeconomic conditions.
Understanding How a High-Yield Bond Spread Works
High-yield bonds, sometimes known as junk bonds, offer enticing interest rates due to their heightened default risk. Unlike government or investment-grade corporate bonds, high-yield bonds have lower credit ratings but attract investors with higher yields. The low correlation of high-yield bonds to other fixed income sectors, along with less sensitivity to changes in interest rates, makes them excellent tools for portfolio diversification.
For junk bonds, the greater the default risk, the higher the interest rate they command. Investors use the high-yield bond spread to gauge the inherent risk level of these bonds. This spread calculates the difference between yields from low-grade bonds and stable, high-grade securities or comparable government bonds.
If the spread increases, the perceived risk of high-yield bonds also rises, offering higher potential returns. Essentially, a higher yield bond spread translates to a greater risk premium. Investors willing to accept these higher risks seek a premium, or greater earnings potential, in return.
High-yield bonds are commonly assessed by their yield spread compared to U.S. Treasury bonds. For example, a financially weaker company will have a higher spread relative to Treasury bonds, unlike a financially stable company, which will have a lower spread relative to these Treasuries. If Treasury bonds yield 2.5% and low-grade bonds yield 6.5%, the credit spread is 4%, or 400 basis points. High-yield bond spreads surpassing historical averages suggest a notable rise in credit and default risk.
Benefits of High-Yield Bond Spreads
Financial analysts and investors utilize high-yield spreads to scrutinize the overall credit market landscape. Variations in a company’s perceived credit risk introduce credit spread risks. For instance, if lower oil prices adversely impact various firms, the high-yield spread or credit spread tends to widen, resulting in higher yields and falling bond prices.
When the investor market displays low risk tolerance, it turns towards stable investments, swelling the spread. Expanding spreads signify elevated default risks in junk bonds, mirroring the corporate economy or a broader downturn in macroeconomic conditions.
The main utility of high-yield bond spreads lies in their historical context, enabling investors to assess today’s spread against past averages. An excessively narrow spread might discourage savvy investors from purchasing junk bonds. Conversely, investments in high-yield bonds seem alluring when spreads exceed their historical average.
Related Terms: basis points, risk premium, interest rate sensitivity, credit risk, Treasury bond, default risk.
