Yield Spread

A yield spread is defined as a difference between debt investments’ yields that is formed by subtracting the yield of one asset from another one. These debt instruments may differ from each other in terms of maturity, assigned credit rating or level of risk. The yield spread is most often expressed in basis points (bps) or in percentage terms.

The yield spread is most commonly indicated in the view of yield relative to US Treasuries or yield relative to top-rated corporate bonds. In the case of the U.S. Treasury bonds, the yield spread is also known as credit spread.

If the ten-year Treasury bond has a yield of 5% and the twenty-year Treasury bond is at the level of 7%, then the yield spread between these debt instruments is 2%. 

What is a Yield Spread

To assess the level of expenses on bonds by investors, the yield spread is one of the main indicators. When a bond A has a yield of 5% and a yield of a bond B is 7%, the yield spread will be 2%, corresponding to 200 basis points. When valuing non-Treasury bonds, the difference between their yield and the yield on Treasuries with similar maturity is usually taken into account. The difference in yield between treasury and corporate bonds that have the same maturity is reflected through a bond credit spread.

Debt issued by the US Treasury is considered to be a measure or even a benchmark in the field of finance, mainly due to minimal risk status, based on the full faith and credit of the American government. The possibility of default on US Treasury bonds is minimal, which is why these instruments are the least risky and investors believe that they will be repaid. As a rule, the higher the bond yield spread of or asset class, the higher the risk. In the event that an investment instrument is considered risky, this implies the payment of compensation to the investor through a high yield spread. 

Thus, a US Treasury bond trades at a relatively high yield spread relative to a corporate bond issued by a corporation with stable financial strength. In the opposite situation, if a corporate bond is issued by a smaller company with a weaker financial in finance, then it has a higher yield spread compared with treasury bonds issued by the government. 

This explains the significant difference in yields between bonds traded in emerging and developed markets, or simply having different maturities. A frequently changing bond yield is followed by a frequently changing yield spread. A growth or widening in the yield spread direction indicates an increase in the yield difference between comparable bonds. The narrower the spread, the smaller the yield difference. For instance, the yield on a high-yield bond rises from 5% to 5.5%, but the yield on the 10-year Treasury is still at the level of 3%. The yield spread widened from 200 to 250 (bps), demonstrating that high-yield bonds have lagged behind treasuries in this period of time. 

Using yield spreads between Treasury bonds with different maturities, investors can conduct an ongoing assessment of economic conditions. A positive yield curve as a result of spread widening signals the stability of the economy in the future, and vice versa, a flattening yield curve due to narrowing of the spread tells the investor about the upcoming deterioration in the economy.

Yield Spread types

Several types of yield spreads can be distinguished.

Zero-volatility spread (Z-spread). This method determines the spread that the investor implemented all along the Treasury spot-rate curve, in the event if the bond is held to maturity. Calculating a zero-volatility spread is quite a labor-intensive and time-consuming process that is carried out by trial and error.

High-Yield Bond Spread. This spread is defined as the percentage difference between current bond yields of different classes of high-yield bonds and some bond benchmarks, such as highly rated corporate bonds or Treasuries. For junk bonds, high credit and default risks are associated with a wider high-yield bond spread.

Option-Adjusted Spread (OAS). The purpose of an option-adjusted spread (OAS) is to convert the difference between the fair price and the real price in the market, which is in dollars, and then convert that value into a yield. It is a situation where interest rate volatility plays an important role. When calculating the value of a security, the option embedded in it should be taken into account, as this can affect cash flows.