What Every Investor Should Know About Yield Spread
The yield spread is one of the key metrics that bond investors can use to gauge how expensive or cheap a particular bond – or group of bonds – might be.
Very simply, the yield spread is the difference in the yield between two bonds. If one bond is yielding 5% and another 4%, the “spread” is one percentage point. Spreads are typically expressed in “basis points,” which is one-hundredth of a percentage point. Hence, a one-percentage-point spread is typically said to be “100 basis points.” Non-Treasury bonds are generally evaluated based on the difference between their yield and the yield on a U.S. Treasury bond of comparable maturity.
Paying Investors for Risk
Generally speaking, the higher-risk a bond or asset class is, the higher its yield spread. There's a simple reason for this: Investors need to be compensated for trickier propositions. If an investment is seen as being low risk, market participants don’t require a huge incentive, or yield, to devote their money to it. But if an investment is seen as being higher risk, people naturally will demand adequate compensation – a higher yield spread – to take the chance that their principal could decline.
For example, a bond issued by a large, stable, and financially healthy corporation will typically trade at a relatively low spread in relation to U.S. Treasuries. Conversely, a bond issued by a smaller company with weaker financials will trade at a higher spread relative to Treasuries. This explains the yield advantage of non-investment grade (high yield) bonds relative to higher-rated, investment-grade bonds. It also explains the gap between higher-risk emerging markets and the usually lower-risk bonds of developed markets.
The spread is also used to calculate the yield advantage of similar securities with different maturities. The most widely used is the spread between the two- and 10-year Treasuries, which shows how much extra yield an investor can get by taking on the added risk of investing in longer-term bonds.
Translating Yield Spread Movements
Yield spreads are not fixed, of course. Because bond yields are always in motion, so too are spreads. The direction of the yield spread can increase, or “widen,” which means that the yield difference between two bonds or sectors is increasing. When spreads narrow, it means the yield difference is decreasing.
Keeping in mind that bond yields rise as their prices fall, and vice versa, a rising spread indicates that one sector is performing better than another. Say the yield on a high-yield bond index moves from 7% to 7.5%, while the yield on the 10-year U.S. Treasury stays even at 2%. The spread moves from 5 percentage points (500 basis points) to 5.5 percentage points (550 basis points), indicating that high-yield bonds underperformed Treasuries during this time.
The bottom line: There’s no such thing as a free lunch – aka super-strong but no-risk return – in the financial markets. If a bond or bond fund is paying an exceptionally high yield, there’s a reason for it: Anyone who holds that investment is also taking on more risk. As a result, investors should be aware that by simply picking fixed-income investments with the highest yield, they could be endangering their principal more than they bargained for.