Definition and Examples of Yield Spread
Yield spread is one of the key metrics that bond investors can use to evaluate how expensive or cheap a particular bond or group of bonds is. In the simplest terms, the yield spread is the difference in yield between two bonds.
How Yield Spread Works
The yield spread is not static, of course. Since bond yields are always in motion, spreads are moving as well. A yield spread can widen, or “expand,” meaning the difference in yield between two bonds or sectors is increasing. When spreads tighten, it means the yield difference is decreasing.
For example, if the yield on a high-yield bond index rises from 8% to 8.5%, while the yield on a 10-year U.S. Treasury bond remains steady at 2%, the spread moves from 6 percentage points (600 basis points) to 6.5 percentage points (650 basis points), indicating that high-yield bonds are underperforming Treasuries during this time.
What This Means for Individual Investors
Generally, the riskier the bond or asset class, the greater the yield spread. Here’s a simple reason for that: investors need to be compensated for taking on more difficult propositions.
If an investment is considered low-risk, market participants do not need a significant incentive, or yield, to commit their money to it. But if the investment is considered high-risk, people will demand sufficient compensation – a higher yield spread – to invest in it and bear the chance that their capital might decrease.
For example: a bond issued by a large, stable, and financially healthy company will typically trade at a relatively low spread compared to U.S. Treasury bonds. Conversely, a bond issued by a smaller company with weaker finances will trade at a higher spread compared to U.S. Treasury bonds.
This explains the yield advantage for non-investment-grade bonds (high yield) compared to higher-rated investment-grade bonds. It also explains the gap between high-risk emerging markets and typically lower-risk bonds in developed markets.
The spread is also used to calculate the yield advantage for similar securities with different maturities. The most widely used is the gap between two-year and ten-year Treasury bonds, which shows the amount of additional yield an investor can earn by taking on the extra risk of investing in long-term bonds.
Yield Spread: A Summary
There is no such thing as a free lunch – strong yields but no risk – in financial markets. If a bond or bond fund is yielding unusually high, there’s a reason for that. Anyone who owns that investment is also taking on more risk.
As a result, investors should be aware that by choosing higher-yielding fixed-income investments, they may be exposing their capital to more risk than they expect.
Source: https://www.thebalancemoney.com/what-is-a-yield-spread-417077
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