What Is Yield Spread & How It Works?

What is 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.

When yield spreads expand or contract, it can signal changes in the underlying economy or financial markets.

How does Yield Spread work?

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.

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 Government Securities. In contrast, a bond issued by a smaller company with weaker financial strength typically trades at a higher spread relative to G-Secs. 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.

Factors affecting Yield Spread
Changes in the yield spread are due to changes in the interest rates, supply and demand of bonds, the risk associated with the bond and economic conditions. The following are some of the factors explained:

• Interest Rates: Any change in interest rates causes the yield on government bonds to change. Since other types of bonds are benchmarked against G-sec yield, any change in G-sec yield may cause other bond yields to change.
• Economic Conditions and Credit Risk: When there is an economic slowdown, company performances are impacted which increase their credit risk. This causes yields on corporate bonds (or PSU, bank bonds) to increase, to compensate investors for the additional risk involved, thereby widening yield spread. When the economy is booming, company profitability increases improving their performance lowering their credit risk. This causes investors to view investments in corporate bonds as favourable, causing yields to fall, thereby narrowing yield spread. Also, during a booming economy with lower credit risk, investors invest in corporate bonds rather than government bonds. Since the demand for government bonds fall, it causes their yields to rise.

Key Takeaways

• Yield spreads are dependent on maturities, credit ratings, issuer, or risk level of bonds
• Yield spreads help understand the underlying economy, sector and financial markets by expanding or contracting
• Riskier the bond, higher is its yield spread as investors have to be adequately compensated for taking higher risk
• Market interest rates have a direct impact on yield spreads