how yield spreads work
the yield spread is a key metric that bond investors use when gauging the level of expense for a bond or group of bonds if one bond yields 7 and another one yields 4 the spread is three percentage points or 300 bps non treasury bonds are generally evaluated based on the difference between their yield and that of a treasury bond of comparable maturity typically the higher the risk a bond or asset class carries the higher its yield spread when an investment is viewed as low risk investors do not require a large yield for tying up their cash however if an investment is viewed as a higher risk investors demand adequate compensation through a higher yield spread in exchange for taking on the risk of their principal declining because bond yields often change yield spreads change too let s say the yield on a high yield bond index increases to 7 5 from 7 meanwhile the 10 year treasury yield remains at 2 the spread moved from 500 basis points to 550 basis points the difference between the bond and the 10 year u s treasury which indicates that high yield bonds underperformed treasuries during that period yield spreads can be used to help predict recessions and economic recoveries and may indicate how investors view economic conditions widening spreads typically lead to a positive yield curve indicating stable economic conditions in the future but when falling spreads contract worsening economic conditions may be coming resulting in a flattening of the yield curve yield spread vs credit spreada bond credit spread reflects the difference in yield between a treasury and corporate bond of the same maturity debt issued by the united states treasury is used as the benchmark in the financial industry due to its risk free status being backed by the full faith and credit of the u s government us treasury government issued bonds are considered to be the closest thing to a risk free investment as the probability of default is almost non existent investors have the utmost confidence in getting repaid types of yield spreadsthere are a few different types of yield spreads including the zero volatility high yield bond and the option adjusted spread we explore these in a little more detail below a zero volatility spread z spread measures the spread realized by the investor over the entire treasury spot rate curve assuming the bond would be held until maturity this method can be a time consuming process as it requires a lot of calculations based on trial and error you would basically start by trying one spread figure and run the calculations to see if the present value of the cash flows equals the bond s price if not you have to start over and keep trying until the two values are equal the high yield bond spread is the percentage difference in current yields of various classes of high yield bonds compared against investment grade e g aaa rated corporate bonds treasury bonds or another benchmark bond measure high yield bond spreads that are wider than the historical average suggest greater credit and default risk for junk bonds an option adjusted spread oas converts the difference between the fair price and market price expressed as a dollar value and converts that value into a yield measure interest rate volatility plays an essential part in the oas formula the option embedded in the security can impact the cash flows which is something that must be considered when calculating the value of the security example of a yield spreadlet s say a bond issued by a large financially healthy company typically trades at a relatively low spread in relation to u s treasuries in contrast a bond issued by a smaller company with weaker financial strength typically trades at a higher spread relative to treasuries for this reason bonds in emerging markets and developed markets as well as similar securities with different maturities typically trade at significantly different yields 