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The yield spread is the difference in interest rates of two bonds having various characteristics, such as varying credit ratings, maturities, or other characteristics. It serves as an indicator of how much more investors desire to lend money to one issuer compared to another.
The yield spread is 2%, for instance, when the yield on a 10-year US Treasury bond is 2% and the yield on a 10-year corporate bond is 4%. As a result, investors need a greater rate of return to invest in corporate bonds, which are riskier than Treasury bonds.
Yield spread can be used to evaluate the relative attractiveness of various bonds as well as the economy's and bond market's general health. A bigger yield spread denotes greater risk and unpredictability in the market, whereas a lower yield spread denotes greater confidence and stability.
Some common types of yield spread are:
- Credit spread: The difference between the yields of bonds with different credit ratings. For example, the difference between a AAA-rated bond and a BBB-rated bond.
- Term spread: The difference between the yields of bonds with different maturities. For example, the difference between a 2-year bond and a 10-year bond.
- Swap spread: The difference between the yield of a fixed-rate bond and the swap rate for the same maturity. For example, the difference between a 5-year bond and a 5-year interest rate swap.
- Option-adjusted spread: The difference between the yield of a bond with embedded options (such as callable or putable bonds) and the yield of a comparable bond without options.
Investors can use yield spread to analyze various bonds and spot any potential market dangers or opportunities. A sign that one of two bonds is overpriced or underpriced can be the credit spread between them, for instance, if it is excessively broad or too tight in comparison to its historical average. Likewise, if the term spread is wide or narrow relative to its historical average, it can mean that investors anticipate higher or lower future interest rates.
The market's perceptions and predictions about the economy and monetary policy can also be reflected in yield spread. A steeper term spread, for instance, would arise from investors demanding higher yields on longer-term bonds if they are positive about the economy and anticipate rising inflation and interest rates. In contrast, if investors are doubtful about the state of the economy and anticipate lower inflation and interest rates, they would favor shorter-term bonds, which would produce a flatter term spread.
The market's perceptions and predictions about the economy and monetary policy can also be reflected in yield spread. A steeper term spread, for instance, would arise from investors demanding higher yields on longer-term bonds if they are positive about the economy and anticipate rising inflation and interest rates. In contrast, if investors are doubtful about the state of the economy and anticipate lower inflation and interest rates, they would favor shorter-term bonds, which would produce a flatter term spread.
