When spreads widen between bonds with different quality ratings it implies that the market is factoring more risk of default on lower grade bonds. For example, if a risk-free 10-year Treasury note is currently yielding 5% while junk bonds with the same duration are averaging 7%, the spread between Treasuries and junk bonds is 2%. If that spread widens to 4% (increasing the junk bond yield to 9%), the market is forecasting a greater risk of default which implies a slowing economy. A narrowing of spreads (between bonds of different risk ratings) implies that the market is factoring in less risk (due to an expanding economy).
Yield Spread Analysis
Yield spread analysis is made by comparing the maturity, liquidity and creditworthiness of two instruments, or of one security to a benchmark. When referring to the “yield spread of X over Y,” it is just the percentage return on investment from one financial instrument labelled as X less the percentage return on investment from another instrument labelled as Y. In simple terms, the analysis is a method to compare any two financial vehicles for an investor to determine his options by analysing risk and return of investment.
The yield spread analysis also helps investors and interested people understand the market’s trend when it comes to various investment instruments. When the spread is wide between bonds of different quality ratings, the investors can conclude that the market is factoring more risk of default on the lower grade bonds, which implies that the economy is slowing down and thus that the market is predicting a greater risk of default.
On the other hand, when the spread is narrowing between different bonds of different risk ratings, the market is considered to have forecasted a lesser default risk brought about by an expanding economy. As an example, when the spread between junk bonds and Treasury notes is four percent historically, the market is generally concluded to be factoring lesser risk of default. Moreover, the yield spread analysis is also beneficial when you are a lender because it can help you determine your profitability when you provide a loan to a borrower.
As an example, when a borrower is sufficiently capable to take advantage of a loan at five percent interest rate but will actually take a loan at six percent, the difference of one percent is the yield spread, which is the additional interest that serves as additional profit for the lender. As a strategy, many lenders offer premiums to loan brokers who offer loans with yield spreads. This is to encourage brokers to search for borrowers willing to pay for the yield spreads.
Yield spread analysis assumes that there exists a normal relationship between the yields for bonds in alternative sectors. The spread is seen to increase during periods of recession and decreases during periods of expansion. There are three ways by which spreads will be affected.
- Yield volatility and the behavior of embedded options
- The effect of yield volatility on the business cycle
- Yield volatility and transaction liquidity
In U.S. consumer loans, particularly home mortgages, a yield spread is the difference between the interest rate actually paid by the borrower on a particular loan and the (lower) interest rate that the borrower's credit would allow that borrower to pay. For example, if a borrower's credit is good enough for a lender to make a loan at 6.0%, but the borrower actually takes out a loan at 6.5%, the 0.5% difference in the interest rates is the yield spread.
As the lender earns additional interest on the loan without assuming additional risk (the borrower's credit is the same), this is a source of additional profit for the lender. In order to encourage loan brokers to find borrowers who will pay yield spreads, lenders typically offer yield spread premiums to the brokers who bring them loans with yield spreads.
- Michael Simkovic, Leveraged Buyout Bankruptcies, the Problem of Hindsight Bias, and the Credit Default Swap Solution Columbia Business Law Review, Vol. 2011, No. 1, p. 118, 2011