A yield spread is the difference in yield between two bonds or two types of bonds. It can be used to compare the maturity, credit rating, liquidity and risk of two bonds, or of one bond to a benchmark. This difference can be measured in the following ways:
Absolute yield spread or nominal spread:
(yield on the subject bond) – (yield on the benchmark bond)
Treasuries are often chosen to be a benchmark. Expressed in basis points.
Relative yield spread:
(absolute yield spread) / (yield on the benchmark bond)
Usually expressed as a percentage.
(subject bond yield) / (benchmark bond yield)
Equal to one plus the relative yield spread.
Intermarket sector spreads refer to yield spreads between two bonds in different sectors of the market. Intramarket sector spreads refer to yield spreads between two bonds in the same market sector. For example, Company A has just issued a 100mm bond due in 5 years with a 5% Yield to Maturity and the bond was rated A- by S&P. Company B issued an identical bond except the bond was sold with a 6% yield to maturity because the bond was rated BBB. The 1% difference in yield in this instance is an intramarket sector spread, however, because the 1% difference was due to a credit rating difference it is also called a credit spread.
Some of the factors affecting yield spread are:
- Economic Strength: In a strong economy, credit spreads tend to narrow as corporations are expected to generate strong cash flows and less likely to default. During a weak economy, credit spreads tend to increase as the chance of companies going bankrupt and defaulting on bonds is higher.
- Embedded options: Yield spreads to a benchmark bond are higher for bonds with call options or prepayment options, but lower for bonds with put options or conversion options, compared to an identical option free bond.
- Liquidity: bonds with less liquidity tend to have a higher credit spread