What Is a Yield Spread?
A yield spread is the difference between yields on differing debt instruments of varying maturities, credit ratings, issuers, or risk levels. The yield spread is calculated by subtracting the yield of one instrument from the other, and this difference is most often expressed in basis points (bps) or percentage points.
Yield spreads are commonly quoted in relation to U.S. Treasuries, where they are called the credit spread. For example, if the five-year Treasury bond stands at 5% and the 30-year Treasury bond is at 6%, the yield spread between these two instruments is 1%. If the 30-year bond trades at 6%, and assuming historical yield spreads, the five-year bond should ideally trade at around 1%, making it very attractive at its current yield of 5%.
Key Takeaways
- Yield spread is a difference in quoted returns on different debt instruments, often varying in maturities, credit ratings, and risk levels.
- To calculate the spread, subtract the yield of one from the other, typically stated in basis points or percentages.
- Spreads are often considered against U.S. Treasuries or AAA-rated corporate bonds.
- Changes in yield spreads can signal shifts in the underlying economy or financial markets.
- There are various types of yield spreads, including zero-volatility spreads, high-yield bond spreads, and option-adjusted spreads.
How Yield Spreads Work
The yield spread is a crucial metric bond investors use to gauge the expense related to a bond or a group of bonds. For example, if one bond has a yield of 7% and another yields 4%, the spread is three percentage points or 300 basis points. Non-Treasury bonds are often evaluated based on their yield difference relative to Treasury bonds of comparable maturity.
Typically, higher-risk bonds or asset classes need to offer higher yield spreads to compensate investors for taking on increased risks. Contrastingly, low-risk investments require smaller yields as a trade-off for tying up capital. Here’s how changing bond yields affect spreads:
- If the spread increases or widens, the yield difference between the two bonds increases, showcasing that one sector perhaps outperforms another.
- When spreads narrow, the yield difference decreases, indicating one sector is underperforming vis-à-vis another.
Suppose the yield on a high-yield bond index jumps to 7.5% from 7%, while the 10-year Treasury yield remains steady at 2%. This spread would have widened from 500 basis points to 550 basis points, signaling that high-yield bonds have underperformed relative to Treasuries during this time.
Yield spreads can serve as indicators for forecasting recessions and economic recoveries, providing insights into how investors perceive the economic environment. Generally, widening spreads indicate future stable economic conditions, while contracting spreads can signal potential economic downturns.
Yield Spread vs. Credit Spread
A credit spread reflects the difference between the yield of a Treasury bond and a corporate bond of the same maturity. U.S. Treasury bonds are the industry benchmark due to their near-zero default risk, backed by the full faith and credit of the U.S. government.
Treasury bonds are considered risk-free, and investors have supreme confidence in the repayment of these debts. Therefore, any difference noted in spreads—for instance, between a Treasury bond and a corporate bond—can highlight the additional risk present in the corporate bond and demand higher yields.
Types of Yield Spreads
Zero-Volatility Spread (Z-Spread)
A zero-volatility spread (Z-spread) measures the spread the investor realizes over the entire Treasury spot-rate curve, assuming the bond is held until maturity. Calculating this requires iterative trial and error until the present value of cash flows equals the bond’s price.
High-Yield Bond Spread
The high-yield bond spread refers to the percentage difference in current yields of different classes of high-yield bonds versus investment-grade (e.g., AAA-rated) corporate bonds, Treasury bonds, or another benchmark. Wider high-yield bond spreads imply greater credit and default risk.
Option-Adjusted Spread (OAS)
An option-adjusted spread (OAS) converts the difference between the fair price and market price into a yield measure considering interest rate volatility. The embedded options impact the cash flows, necessitating considerations of these in the valuation.
Example of a Yield Spread
Consider a bond issued by a large, financially healthy corporation that typically trades at a relatively low spread compared to U.S. Treasuries. Conversely, a bond issued by a smaller company with weaker financial strength generally trades at a higher spread versus Treasuries. Bonds from emerging and developed markets and similar securities with different maturities often trade at significantly different yields due to varying assessments regarding risk.
Can Yield Spreads Forecast Future Economic Performance?
Yield curves provide insights into the economic outlook and are often considered leading economic indicators. When spreads widen, it creates a positive yield curve, suggesting future economic growth. Conversely, a flattening yield curve reflecting a narrowing spread often predicts upcoming economic difficulties.
What Is a Yield Spread Premium?
A yield spread premium is compensation paid to mortgage brokers by lenders when the brokers provide loans at higher-than-standard interest rates. This premium does not include other costs typically borne by borrowers, such as commissions or miscellaneous fees.
The Bottom Line
For savvy investors or fund managers, yield spreads offer a critical metric for determining the best investments. By examining the differences between investments, particularly bonds, you can identify which are affordable or expensive relative to each other, ultimately guiding more informed investment decisions.
Related Terms: Credit Spread, Zero-Volatility Spread, Option-Adjusted Spread, Treasury Bond.
