Table of Contents

Yield Spread: Definition, How It Works, and Types of Spreads

By

James Chen

Updated October 10, 2020

Reviewed by

Somer Anderson

Fact checked by

Ariel Courage

What Is a Yield Spread?

A yield spread is the difference between yields on differing debt instruments of varying maturities, credit ratings, issuers, or risk levels. A yield spread is calculated by deducting the yield of one instrument from the other. This difference is most often expressed in basis points (bps) or percentage points.

Yield spreads are commonly quoted in terms of one yield versus that of U.S. Treasuries, where it is called the credit spread. For example, if the five-year Treasury bond is at 5% and the 30-year Treasury bond is at 6%, the yield spread between the two debt instruments is 1%. If the 30-year bond is trading at 6%, then based on the historical yield spread, the five-year bond should be trading at around 1%, making it very attractive at its current yield of 5%.

Key Takeaways

A yield spread is a difference between the quoted rate of return on different debt instruments which often have varying maturities, credit ratings, and risk.
The spread is straightforward to calculate since you subtract the yield of one from that of the other in terms of percentage or basis points.
Yield spreads are often quoted in terms of a yield versus U.S. Treasuries, or a yield versus AAA-rated corporate bonds.
When yield spreads expand or contract, it can signal changes in the underlying economy or financial markets.
Yield spreads can come in varying types, including zero-volatility spreads, high-yield bonds spreads, and option-adjusted spreads.

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:

The direction of the spread may increase or widen, meaning the yield difference between the two bonds increases, and one sector performs better than another.
When spreads narrow, the yield difference decreases and one sector performs more poorly than another.

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 Spread

A 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 Spreads

There 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.

Zero-Volatility Spread (Z-Spread)

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.

High-Yield Bond Spread

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.

Option-Adjusted Spread (OAS)

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 Spread

Let'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.

What Is a Yield Spread?

The difference in yields on two debt instruments that have different maturity dates, issuers, credit ratings, or risk levels is known as the yield spread. Yield spreads are commonly reported in percentage or basis points. In order to determine the yield spread, you must subtract one investment's yield from that of the other.

Can Yield Spreads Forecast Future Economic Performance?

Yield curves are valuable tools that can shed light on the economy, which means they can be used to help forecast whether a recession or a recovery is on the horizon. As such, they are often considered leading economic indicators. When spreads widen, it leads to a positive yield curve. This means that the economy is expected to grow in the future. But when the yield curve flattens, it generally indicates that short-term rates are falling. The expectation here is that the economy won't be doing very well in the future.

What Is a Yield Spread Premium?

A yield spread premium is a type of compensation paid to mortgage brokers. These individuals receive this fee from lenders when they give borrowers mortgage loans with interest rates that are higher than the lender's standard rate. The yield spread premium doesn't include any additional costs that borrowers are typically responsible for, such as commissions or other fees.

The Bottom Line

If you're a savvy investor or a fund manager, you can figure out what the best investments are for you or your clients using different metrics, including yield spreads. This is the difference between two investments (notably bonds) with different maturities, issuers, credit ratings, and risks. You can also use yield spreads to figure out which bonds tend to be affordable or expensive.

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