Yield Spread

What Is a Yield Spread?

A yield spread is the difference between yields on differing debt instruments of varying maturities, credit ratings, issuer, or risk level, calculated by deducting the yield of one instrument from the other. This difference is most often expressed in basis points (bps) or percentage points.

Yield spreads are commonly quoted in terms of one yield versus that of U.S. Treasuries, where it is called the credit spread. For example, if the five-year Treasury bond is at 5% and the 30-year Treasury bond is at 6%, the yield spread between the two debt instruments is 1%. If the 30-year bond is trading at 6%, then based on the historical yield spread, the five-year bond should be trading at around 1%, making it very attractive at its current yield of 5%.

Understanding Yield Spread

The yield spread is a key metric that bond investors use when gauging the level of expense for a bond or group of bonds. For example, if one bond is yielding 7% and another is yielding 4%, the spread is 3 percentage points or 300 basis points. Non-Treasury bonds are generally evaluated based on the difference between their yield and the yield on a Treasury bond of comparable maturity.

A bond credit spread reflects the difference in yield between a treasury and corporate bond of the same maturity. Debt issued by the United States Treasury is used as the benchmark in the financial industry due to its risk-free status being backed by the full faith and credit of the U.S. government. US Treasury (government-issued) bonds are considered to be the closest thing to a risk-free investment, as the probability of default is almost non-existent. Investors have the utmost confidence in getting repaid.

Typically, the higher the risk a bond or asset class carries, the higher its yield spread. When an investment is viewed as low-risk, investors do not require a large yield for tying up their cash. However, if an investment is viewed as a higher risk, investors demand adequate compensation through a higher yield spread in exchange for taking on the risk of their principal declining.

For example, a bond issued by a large, financially-healthy company typically trades at a relatively low spread in relation to U.S. Treasuries. In contrast, a bond issued by a smaller company with weaker financial strength typically trades at a higher spread relative to Treasuries. For this reason, bonds in emerging markets and developed markets, as well as similar securities with different maturities, typically trade at significantly different yields.

Because bond yields are often changing, yield spreads are as well. The direction of the spread may increase or widen, meaning the yield difference between the two bonds is increasing, and one sector is performing better than another. When spreads narrow, the yield difference is decreasing, and one sector is performing more poorly than another. For example, the yield on a high-yield bond index moves from 7% to 7.5%. At the same time, the yield on the 10-year Treasury remains at 2%. The spread moved from 500 basis points to 550 basis points, indicating that high-yield bonds underperformed Treasuries during that time period.

When compared to the historical trend, yield spreads between Treasuries of different maturities may indicate how investors are viewing economic conditions. Widening spreads typically lead to a positive yield curve, indicating stable economic conditions in the future. Conversely, when falling spreads contract, worsening economic conditions may be coming, resulting in a flattening of the yield curve.

Types of Yield Spreads

A zero-volatility spread (Z-spread) measures the spread realized by the investor over the entire Treasury spot-rate curve, assuming the bond would be held until maturity. This method can be a time-consuming process, as it requires a lot of calculations based on trial and error. You would basically start by trying one spread figure and run the calculations to see if the present value of the cash flows equals the bond’s price. If not, you have to start over and keep trying until the two values are equal.

The high-yield bond spread is the percentage difference in current yields of various classes of high-yield bonds compared against investment-grade (e.g. AAA-rated) corporate bonds, Treasury bonds, or another benchmark bond measure. High-yield bond spreads that are wider than the historical average suggests greater credit and default risk for junk bonds. 

An option-adjusted spread (OAS) converts the difference between the fair price and market price, expressed as a dollar value, and converts that value into a yield measure. Interest rate volatility plays an essential part in the OAS formula. The option embedded in the security can impact the cash flows, which is something that must be considered when calculating the value of the security.