Bonds uncovered: The ins and outs of a yield spread

Julie Brownlee, Fsp Invest, 04 Dec. 2014

Tags: yield spread, yield spreads, bond’s yield spread, bonds, debt securities, how to use yield spreads

If you’ve looked through anything about bonds and other debt securities, you might have come across the term ‘yield spread’.

So what exactly is a yield spread?

Let’s take a closer look…

What is a yield spread?

A yield spread is simply the difference in yields between different bonds or debt securities. Yields are basically the interest rates of bonds.

Yield spreads can be useful if you want to compare the bonds of:

  • Different countries;
  • Different maturities; or
  • Different credit ratings.

By looking at yield spreads, you can see if particular bonds are becoming more or less risky and whether they could be a good investment.

To see how yield spreads works, let’s take a look at an example…

A yield spread in action

Let’s say you look at very safe German ten-year government bonds. The yield is 0.87%.

You look at the same type of bond from the Greek government and its yield is 7.5%.

This gives you a yield spread of 6.63%. Another way to say this is the yield spread is 663 basis points. (One basis point is 0.01%.)

This yield spread shows that Greek government bonds are seen as far more risky than German government bonds.

This is due to the Greek economy being much weaker than the German economy. And the Greek government have a lot more debt than the German government.

This increases the risk that the Greek government might not pay the interest due on the bond. And it might not pay back the original capital.

To entice investors to buy its bonds, the Greek government offers a much higher rate of interest than Germany. This is to compensate investors for the extra risk they’re taking buying Greek government bonds.

Professional investors closely watch the yield spreads between different bonds to gauge whether they’ve become relatively cheap or expensive.

So there you have it, the ins and outs of a yield spread.

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