Yield Spread and its use

29 Apr 2011 Share on:

Meaning

• Yield spread is a way of comparing any two financial products.
• Yield spread is the difference between profit you can make in two different types of investment.

Why do we need to calculate Yield spread?

Before coming to the purpose of calculating yield spread, lets go in a different direction.

When you buy a Government bond, you can be certain that you’ll be paid in full, after the maturity and they’ll not run away. So in this case risk is very low, hence they sell like hot-cakes. That's why they're called "Gilt edged securities"

When risk is low, it doesn’t carry much profit.

But some junk company is issuing bonds, no one has ever heard of them.

So their bonds carry high-risk of default, hence people won't be interested in buying it as such.So,The company will offer extra-high return (profit) on their bonds, to attract people.

In short : Higher return is offered when Risk is HIGH.

Scene 1: Year 2010

For every 100 rs. Invested in Government bond, you get Rs.5 return after 1 year.

For every 100 Rs. Invested in the junk bond, you’re offered Rs.13 return after 1 year.

So yield spread = (13% minus 5%) = 8%

Scene 2: Year 2011

Government  bond’s return remains the same but now that junk bond company is offering you 20% return.

So Yield spread = (20% minus 5%)=15%

In one year, the yield spread has widened from 8% to 15%.

As we saw above, Higher the risk, higher return is offered.

So, 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).

# As described by Mrunal