Market fluctuations are always a concern for an investor and especially if it is a high-yield bond. Generally, the focus is on getting safer higher returns as the penny invested is much dear to us. If you have invested in high-yield bonds, then this needs a little attention to all the risks, especially with the credit risk. It’s time, you analyze the risks before investing in high-yield bonds. And that can be achieved using a high yield bond spread.
What is High Yield Bond Spread?
A high-yield bond spread, also termed a credit spread, is a concept of calculating the yield difference between two bonds of different classes at the same maturity. So the comparison here is between the High Yield Bond (High Risk) and the Investment Grade Bond (Low Risk). This serves as the primary indication for the investors to assess the credit risk associated with the bonds before investing.
How to calculate high-yield bond spread?
It is the difference in the yield of high yield bond minus the yield of an investment grade bond.
High yield bond spread = Yield of high yield bond – Yield of investment grade bond or government bond (Calculated in terms of percentage or basis points)
For instance, consider the high yield bond with a yield of 7% and a government bond with a yield of 4%.
Then,
High yield bond spread = 7 – 4
High yield bond spread = 3%
Let’s understand high-yield bond spread from a better perspective in a scenario.
Scenario:
For instance, consider the low-grade bond yields of 7.5% and government bond yields of 4% in 2020.
The high yield bond spread = 7.5 – 4
The high yield bond spread = 3.5% or 350 basis points
Widen high yield bond spread scenario:
The low-grade bond yields by 8.5% and the government bond yields by 4% in 2022.
The high yield bond spread = 8.5 – 4
The high yield bond spread = 4.5% or 450 basis points
It is seen that the high yield spread has widened compared to 2020.
Narrow high yield bond spread scenario:
The low-grade bond yields by 6.5% and the government bond yields by 4% in 2024.
The high yield bond spread = 6.5 – 4
The high yield spread = 2.5% or 250 basis points
This year it is seen that the high yield spread has narrowed compared to 2020.
So whenever the high yield bond spread widens, it indicates that the economy is worsened and when the high yield spread is narrowed it means the economy is in good condition.
Why is high-yield bond issued?
As we know that the high yield bonds are the bonds that come with a risk premium, we know that the higher returns aren’t coming risk-free. Since the issuer’s credit rating is low, they don’t have any choice but to issue bonds in exchange for the higher interest rate to finance their operational needs.
While that leaves the investor to choose whether to invest in the high-yield bond or not because it comes with high returns and can be tempting. So as the high yield bond spread gives the difference between the yields of the two bonds, it analyzes the risk associated with the bonds.
What are high-yield bonds?
The inverse relationship between bond yield and bond price
The high yield bond spread deduces the inverse relationship between the bond price and the bond yield.
For instance,
The low-grade bond is at a price of 1200 Rs and yields 7.5% in 2022. The same bond is at a bond price of 800 Rs and yields 8.5% in 2024. While the government bond is at 1000 Rs all throughout yielding 4%.
It can be concluded that in 2024 the low-grade bond yielded high and that it underperforms the government bond. Note that the yields are always subject to change.
This is the inverse relationship the high yield spread speaks about. When the bond price increases, the yield decreases. Similarly when the bond price decreases, the yield increases.
So an increase in the bond yield conveys that the high yield bond spread is widened and it has a high risk associated with it. While the decrease in the bond yield indicates that the high yield bond spread is narrowed and there is lower risk associated with the investment. In turn, also indicates that one sector outperforms the other, and identifying it becomes easier.
How does bond price impact yield?
Closing Thoughts
If you finished reading this then you know that your risk appetite is much larger and yet you want to be in a safer play. Analyzing high-yield bond spreads lets you be aware of the additional risk that you may want to take as an investor. And mainly to decide upon which bonds to go with, if at all, by gauging the high yield bond spread.
In all, the narrower the credit spread, the lower the risk and the greater the economic conditions. While wider the credit spread, the higher the risk and worse the economic condition. Although a narrower credit spread is the safest option, sometimes if the quest is for higher returns then a widened credit spread is the one to go while still keeping track of the high-yield bond spread to hold on as per the risk appetite.
FAQ’S for Yield Bond
What factors affect yield spread?
Factors that affect the yeild bond spread are credit cycle, broader economic conditions, market performance, supply and demand and availability of funding in the financial sector.
How do you measure bond risk?
Bond risk is typically measured by calculating the probability of the bond issuer defaulting on their payments. This can be done using a number of different methods, including looking at the bond issuer’s credit rating, financial history, and current financial situation. Other than that there are tools – Duration and convexity
What do bond spreads tell us?
Bond spreads are the difference in yield between two bonds of different maturities or credit quality. The yield of a bond is the interest rate that the bond pays. The yield of a 10-year Treasury note, for example, is the rate of interest that the bond pays. The yield of a 10-year corporate bond, on the other hand, is the rate of interest that the bond pays plus a risk premium.
