Yield Spread
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Yield Spread
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In the simplest terms, the yield spread is the difference in the yield between two bonds. Using the yield spread, an investor can understand how cheap or expensive a bond is. In order to calculate yield spread, subtract the yield of one bond from the yield of the other bond. Spreads are typically expressed in “basis points,” each of which is one-hundredth of a percentage point. In general, the higher-risk a bond or asset class is, the higher its yield spread.
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Yield spread is one of the key metrics that bond investors can use to gauge how expensive or cheap a particular bond—or group of bonds—might be. In the simplest terms, the yield spread is the difference in the yield between two bonds.
Using the yield spread, an investor can understand how cheap or expensive a bond is. In order to calculate yield spread, subtract the yield of one bond from the yield of the other bond.
If one bond is yielding 5% and another is yielding 4%, the “spread” is one percentage point. Spreads are typically expressed in “ basis points ,” each of which is one-hundredth of a percentage point. Hence, a one-percentage-point spread is typically said to be 100 basis points.
Non-Treasury bonds are generally evaluated based on the difference between their yield and the yield on a U.S. Treasury bond of comparable maturity.
Yield spreads are not fixed, of course. Because bond yields are always in motion, so too are spreads. The direction of the yield spread can increase, or “widen,” which means that the yield difference between two bonds or sectors is increasing. When spreads narrow, it means the yield difference is decreasing.
Keeping in mind that bond yields rise as their prices fall , and vice versa, a rising spread indicates that one sector is performing better than another.
Say the yield on a high-yield bond index moves from 8% to 8.5%, while the yield on the 10-year U.S. Treasury stays even at 2%. The spread moves from 6 percentage points (600 basis points) to 6.5 percentage points (650 basis points), indicating that high-yield bonds underperformed Treasurys during this time.
Generally speaking, the higher-risk a bond or asset class is, the higher its yield spread. There's a simple reason for this: Investors need to be compensated for trickier propositions.
If an investment is seen as being low risk, market participants don’t require a huge incentive, or yield, to devote their money to it. But if an investment is seen as being higher risk, people naturally will demand adequate compensation—a higher yield spread—to take the chance that their principal could decline.
For example: A bond issued by a large, stable, and financially healthy corporation will typically trade at a relatively low spread in relation to U.S. Treasurys. Conversely, a bond issued by a smaller company with weaker financials will trade at a higher spread relative to Treasurys.
This explains the yield advantage of non-investment grade ( high yield ) bonds relative to higher-rated, investment-grade bonds. It also explains the gap between higher-risk emerging markets and the usually lower-risk bonds of developed markets.
The spread is also used to calculate the yield advantage of similar securities with different maturities. The most widely used is the spread between the two- and 10-year Treasurys, which shows how much extra yield an investor can get by taking on the added risk of investing in longer-term bonds.
There’s no such thing as a free lunch—a super-strong but no-risk return—in the financial markets. If a bond or bond fund is paying an exceptionally high yield, there’s a reason for it. Anyone who holds that investment is also taking on more risk.
As a result, investors should be aware that by simply picking fixed-income investments with the highest yield, they could be endangering their principal more than they were bargaining for.
Corporate Finance Institute. " Basis Points (BPS) ." Accessed March 15, 2021.
U.S. Securities and Exchange Commission. "Interest Rate Risk—When Interest Rates Go Up, Prices of Fixed-Rate Bonds Fall ," Pages 1-3. Accessed March 15, 2021.
American Century Investments. " What's the Yield Curve? " Accessed March 15, 2021.
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The 10-2 Treasury Yield Spread is the difference between the 10 year treasury rate and the 2 year treasury rate. A 10-2 treasury spread that approaches 0 signifies a "flattening" yield curve. A negative 10-2 yield spread has historically been viewed as a precursor to a recessionary period. A negative 10-2 spread has predicted every recession from 1955 to 2018, but has occurred 6-24 months before the recession occurring, and is thus seen as a far-leading indicator. The 10-2 spread reached a high of 2.91% in 2011, and went as low as -2.41% in 1980.
10-2 Year Treasury Yield Spread is at -0.17%, compared to -0.20% the previous market day and 1.12% last year. This is lower than the long term average of 0.92%.
The 10-2 Treasury Yield Spread is the difference between the 10 year treasury rate and the 2 year treasury rate. A 10-2 treasury spread that approaches 0 signifies a "flattening" yield curve. A negative 10-2 yield spread has historically been viewed as a precursor to a recessionary period. A negative 10-2 spread has predicted every recession from 1955 to 2018, but has occurred 6-24 months before the recession occurring, and is thus seen as a far-leading indicator. The 10-2 spread reached a high of 2.91% in 2011, and went as low as -2.41% in 1980.
10-2 Year Treasury Yield Spread is at -0.17%, compared to -0.20% the previous market day and 1.12% last year. This is lower than the long term average of 0.92%.
Change from The Previous Market Day
Change from The Previous Market Day
2. What is the history of the yield spread?
3. How do you read the yield spread?
4. Why does the Fed create recessions and how is this viewed in the yield spread?
5. Can it really forecast the future state of the economy?
6. How do real estate professionals use the yield spread?
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The yield curve spread (or more simply, the yield spread ) is the difference between the:
Over time, changes in the yield spread reflect economic conditions as interpreted by the bond market . It has proven a reliable indicator of economic conditions one year forward. [More on the yield spread’s forecasting reliability on Card 5]
The yield spread is not related to the yield spread premium , which is a kickback paid by mortgage lenders.
The yield spread originated from research at the Federal Reserve Bank of New York (NY Fed) in the 1980s. Economists Arturo Estrella and Gikas A. Hardouvelis published this research in a 1991 article at the NY Fed: The Term Structure as a Predictor of Real Economic Activity. [These articles are found on Card 7]
This seminal paper focused on the yield spread’s ability to predict past recessions. That is, the yield spread was useful in hindsight. Estrella co-authored a second article in 2006 on using the yield spread to forecast economic recessions in real time.
The National Bureau of Economic Research defines a recession as a period of at least three quarters of significantly declining economic activity, including decreasing gross domestic product (GDP) and falling employment.
The yield spread shows us that recessions are completely predictable and in fact planned in order to keep the economy in check.
A normal, “healthy” yield spread is positive . That is, the long-term rate is higher than the short-term rate.
When the short-term rate is higher than the long-term rate, the yield spread becomes inverted, or goes negative . When this happens the probability of recession in the next 12 months is almost certain.
Why does this relationship exist? It all has to do with the interplay between:
The Fed’s use of short-term interest rates and other infusions and withdrawals of dollars to control the economy is known as monetary policy .
On the other end are members of the bond market (a non-government entity). They watch inflation just as closely as the Fed, and:
When the economy is overheating or inflation is rising well beyond the Fed’s target rate of 2%, the Fed tightens monetary policy. Too much inflation leads to an unstable economy, and a more severe bust when the economy does crash. Thus, the Fed maintains control over the economy by creating its own recession.
When a recession is imminent, short-term rates rise and long-term rates fall, reflected in the narrowing spread between the two rates. This is viewed in a decreasing yield spread. In other words, the falling yield spread is not the cause of the coming recession; rather it is a strong indicator that a recession will occur within 12 months.
On the other hand, a widening yield spread indicates little chance of recession and makes a strong case for economic expansion in the coming months.
Yes and no. Yes, the yield spread correctly predicted the 2008 Great Recession, the briefer 2001 recession, the 1989 recession… and all other recessions going back to World War II.
However, movement in the yield spread needs to be considered alongside other economic factors to accurately forecast your local economy. That’s because, despite living in an increasingly globalized economy, the effects of a nationwide recession or economic recovery can vary greatly by location.
For instance, local economic performance depends on:
For example, San Francisco (a coastal city with a large, successful tech industry) recovered all jobs lost in the 2008 recession by October 2013. In contrast, it took Riverside (an inland city mostly considered a bedroom community of Los Angeles and San Diego) nearly two years longer to recover all jobs lost in the 2008 recession.
Thus, the yield spread is helpful on a broad, nationwide scale. A rising yield spread does not signify economic prosperity for all, nor does a falling yield spread herald impending disaster for each and every individual. However, it is a helpful tool to forecast future conditions for your local market when considered alongside other economic indicators.
Keeping an eye on the yield spread is helpful when planning for real estate sales in the year to come.
When the yield spread goes negative, expect a reduced volume of sales (which may by then already be slipping), lending and leasing one year forward. Then, in another 12 months, there will be a drop in real estate prices, mortgage originations and rents. Agents can adjust their conduct to prepare for the coming months of low sales volume and prices.
Read more about using the yield spread and view the yield spread chart at: Using the yield spread to forecast recessions and recoveries .
Read more about buy, sell and hold phases of real estate at: How to time the market .
To read more about how the Fed creates a recession, see: Suspect behavior: why and how the Fed creates a recession .
For access to the original 1991 article positing the yield spread curve as a forecast for economic growth, see: The Term Structure as a Predictor of Real Economic Activity , originally published by the New York Fed. [You may require library access to view the full article]
For an update on using Estrella’s original research to forecast with the yield spread in real time, see Estrella’s 2006 article: The Yield Curve as a Leading Indicator: Some Practical Issues , from the New York Fed.
To read about using the yield spread curve’s level and slope for precise economic forecasting, see: Forecasting with the Yield Curve: Level, Slope, and Output , from the Cleveland Fed.
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Anthony Battle is a CERTIFIED FINANCIAL PLANNER™ professional. He earned the Chartered Financial Consultant® designation for advanced financial planning, the Chartered Life Underwriter® designation for advanced insurance specialization, the Accredited Financial Counselor® for Financial Counseling and both the Retirement Income Certified Professional®, and Certified Retirement Counselor designations for advance retirement planning.
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A high-yield bond spread, also known as a credit spread, is the difference in the yield on high-yield bonds and a benchmark bond measure, such as investment-grade or Treasury bonds. High-yield bonds offer higher yields due to default risk. The higher the default risk the higher the interest paid on these bonds. High-yield bond spreads are used to evaluate credit markets, where rising spreads can signal weakening macroeconomic conditions.
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A yield spread is the net difference between two interest bearing instruments, expressed in terms of percent or basis points (bps).
The bond market is the collective name given to all trades and issues of debt securities. Learn more about corporate, government, and municipal bonds.
A credit spread reflects the difference in yield between a treasury and corporate bond of the same maturity. It also refers to an options strategy.
Michael Milken is a philanthropist and financier known for his investment in junk bonds as an executive at the investment bank Drexel Burnham Lambert.
High-yield bonds (also called junk bonds) are bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds.
Risk takes on many forms but is broadly categorized as the chance an outcome or investment's actual return will differ from the expected outcome or return.
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James Chen, CMT is an expert trader, investment adviser, and global market strategist. He has authored books on technical analysis and foreign exchange trading published by John Wiley and Sons and served as a guest expert on CNBC, BloombergTV, Forbes, and Reuters among other financial media.
A high-yield bond spread is the percentage difference in current yields of various classes of high-yield bonds compared against investment-grade corporate bonds, Treasury bonds, or another benchmark bond measure. Spreads are often expressed as a difference in percentage points or basis points . The high-yield bond spread is also referred to as credit spread.
A high-yield bond, also known as a junk bond, is a type of bond that offers a high rate of interest because of its high risk of default . A high-yield bond has a lower credit rating than government bonds or investment-grade corporate bonds, but the higher interest income or yield draws investors to it. The high-yield sector has a low correlation to other fixed income sectors and has less sensitivity to interest rate , making it a good investment asset for portfolio diversification.
The greater the default risk of a junk bond, the higher the interest rate will be. One measure that investors use to assess the level of risk inherent in a high-yield bond is the high-yield bond spread. The high-yield bond spread is the difference between the yield for low-grade bonds and the yield for stable high-grade bonds or government bonds of similar maturity.
As the spread increases, the perceived risk of investing in a junk bond also increases, and hence, the potential for earning a higher return on these bonds increases. The higher yield bond spread is, therefore, a risk premium . Investors will take on the higher risk prevalent in these bonds in return for a premium or higher earnings.
High-yield bonds are typically evaluated on the difference between their yield and the yield on the U.S. Treasury bond . A company with weak financial health will have a relatively high spread relative to the Treasury bond. This is in contrast to a financially sound company, which will have a low spread relative to the US Treasury bond. If Treasuries are yielding 2.5% and low-grade bonds are yielding 6.5%, the credit spread is 4%. Since spreads are expressed as basis points, the spread, in this case, is 400 basis points.
High-yield bond spreads that are wider than the historical average suggests greater credit and default risk for junk bonds.
High-yield spreads are used by investors and market analysts to evaluate the overall credit markets. The change in the perceived credit risk of a company results in credit spread risk. For example, if lower oil prices in the economy negatively affect a wide range of companies, the high-yield spread or credit spread will be expected to widen, with yields rising and prices falling.
If the general market’s risk tolerance is low and investors navigate towards stable investments, the spread will increase. Higher spreads indicate a higher default risk in junk bonds and can be a reflection of the overall corporate economy (and therefore credit quality) and/or a broader weakening of macroeconomic conditions.
The high-yield bond spread is most useful in a historical context, as investors want to know how wide the spread
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