The yield spread is the difference that occurs between the risk-free rate and the bond yield or even between two comparable assets. The yield spread reflects the difference in yield which indicates the risk between each investment. It is generally expressed as a percentage or basis points. Investors can calculate the yield spread easily once they subtract the yield of one instrument from the other. If the yield spread contracts or expands, then it can be due to the changes in the financial market or the economy. As such, understand how the yield spread works from the following sections and what its different types include.
How Does Yield Spread Work?
The yield spread is used to evaluate the level of expense for a group of bonds or a bond. If a bond yields 8% and another one yields 4%, then the yield spread is 4 percentage points or 400 basis points.. The yield spreads keep on changing due to the change in bond yields.
For instance, yield spread widening or narrowing reflects changes in the perceived risk premium between the bonds. A widening spread generally indicates increased risk or a higher return demanded by investors, while a narrowing spread suggests reduced risk or lower returns.
The Different Types of Yield Spreads
The following are the three different kinds of yield spreads:
Option-Adjusted Spread
An option-adjusted spread or an OAS transforms the difference between the market price and the fair price and converts its value into a yield measure. OAS adjusts for the impact of embedded options, such as call or put features, on bond pricing. It measures the spread between the bond’s yield and the yield of a risk-free rate of return . As such, the interest rate volatility is one of the significant aspects of the option-adjusted spread formula.
High-Yield Bond Spread
The high-yield bond spread is about the percentage difference in the present yields of various classes of high-yield (or junk) bonds compared to any benchmark bond measure. And, if the high-yield bond spread is wider than the average, then there is a greater default and credit risk for junk bonds.
Zero-Volatility Spread
The zero-volatility spread estimates the spread realised by the investor over the rate curve. It works under the assumption that the bond is held till its maturity date, i.e., there are no changes in interest rates over the life of the bond. This spread is analysed by trying one figure and running the calculations to observe whether the cash flow’s present value is equal to the bond’s price.
Wrapping Up!
Understanding the yield spread is incredibly important since it will help investors understand the best investments. It is one of the metrics that compares two or more bonds together with different credit ratings, issuers, maturities and risks. One can also use the spread under which bond is expensive and which one is affordable. This way, you can make the best investment decisions and ensure investing in the right bond.
FAQs About What is Yield Spread?
1. Can yield spreads be used for predicting future economic performance?
Yield spreads can be used to forecast whether the economy will face a recovery or a recession in the future. They are considered one of the best economic indicators. And if your yield spreads, then the economy is expected to grow in the future. But if the spread is narrow then the economy may not perform well.
2. When should I use the yield spread?
Investors should use the yield spread when they want to find the best investment for themselves. It does not have to be at any specific time, but instead depends on when you want to make that estimation and make the best decision possible.
3. What is the difference between yield spread and swap spread?
The yield spread is all about finding the difference between bonds through different sectors or credit qualities. Whereas, swap spreads are about measuring the difference between the government bond yields and swap rates.
