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Yield Spread
Yield spread refers to the difference between the yields of different types of fixed-income securities, such as bonds or loans. It is a measure of the risk premium associated with investing in one type of security over another. A wider yield spread indicates higher perceived risk, while a narrower spread suggests lower risk.
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10 Key excerpts on "Yield Spread"
eBook - ePub- Nikiforos T. Laopodis(Author)
- 2021(Publication Date)
- Routledge(Publisher)
A Yield Spread is a difference between two financial assets’ yields to maturity. The slope of the term structure of interest rates (i.e., the yield curve) is the yield curve spread. For example, the difference between the price at which a dealer is willing to buy a financial asset, the bid, and the price at which he/she is willing to sell that asset, the ask, is the bid–ask spread. In the trading of bonds, the difference between two bonds of the same quality but different maturities is the Yield Spread. The latter can be either a term spread, when taking the difference in yields of two government bonds’ yields, or a credit spread when taking the difference in the yields between a corporate (or any other type of) bond and that of a government bond of the same maturity but of different quality. Finally, in trading in the futures market, the spread relates to the difference in price for the same commodity between delivery months. Next, we discuss various types of yields and Yield Spreads and evaluate them in terms of their significance for the investor. At the same time, we offer a brief refresher on bond valuation. Also, we will discuss the various factor affecting yields and spreads and include some Yield Spread trading strategies. Finally, we will dedicate some discussion on exchange rates, their characteristics and determinants as well as some important parities. We also spend some time on several econometric methodologies and empirical evidence on the fundamental interest-rate parities. 1 Bond yields and spreads We begin with some basic notions/concepts of yields and spreads and continue with some spreads and their interpretation. 1.1 Bond prices and yields To value a bond, we discount its expected cash flows by the appropriate discount rate. The cash flows from a bond consist of coupon payments until the maturity date plus the final payment of par value
eBook - PDFInvestments
Analysis and Management
- Gerald R. Jensen, Charles P. Jones(Authors)
- 2019(Publication Date)
- Wiley(Publisher)
The spread can be interpreted as a risk premium. In this case, the risk premium is compensation for committing wealth to long-term investments in the face of unanticipated inflation shocks. The term spread is positive when the yield curve is upward sloping and negative when the yield curve is inverted. 450 Chapter 17 Bond Yields and Prices The level of interest rates also plays a role in explaining Yield Spreads. As a gen- eral proposition, risk premiums tend to be high when the level of interest rates is high. Yield Spreads over time The size of the Yield Spread changes over time based on changes in perceived risk. Whenever the differences in yield become smaller, the Yield Spread is said to “narrow”; as the differences increase, it “widens.” The credit spread, also called the default premium, is one of the most popular Yield Spreads. The credit spread reflects the difference in yields between a lower- quality bond and a higher-quality bond of comparable maturity. For example, the credit spread is often derived as the YTM of a long-term Baa-rated bond index minus the YTM of a long-term T-bond index. The credit spread commonly widens during periods of economic uncertainty, when investors become more risk-averse, and it narrows during times of economic prosperity. Since the probability of default is greater during a recession, investors demand more of a premium. The credit spread widened substantially in 2008 dur- ing the financial crisis. In contrast, the spread narrowed gradually as the economy recovered in subsequent years. The spread in 2018 was especially low because even financially weak companies have a good chance of surviving and paying their debt obligations when economic growth is strong. Figure 17.2 shows the spread between 10-year Treasuries and Baa corporate bonds, a measure of the credit spread. In 2006 and 2007, the spread was relatively narrow averaging less than 2 percent, which reflected investor confidence in the economy.
eBook - PDFInvestments
Analysis and Management
- Gerald R. Jensen, Charles P. Jones(Authors)
- 2020(Publication Date)
- Wiley(Publisher)
The spread can be interpreted as a risk premium. In this case, the risk premium is compensation for committing wealth to long-term investments in the face of unanticipated inflation shocks. The term spread is positive when the yield curve is upward sloping and negative when the yield curve is inverted. 450 Chapter 17 Bond Yields and Prices The level of interest rates also plays a role in explaining Yield Spreads. As a gen-eral proposition, risk premiums tend to be high when the level of interest rates is high. Yield Spreads over time The size of the Yield Spread changes over time based on changes in perceived risk. Whenever the differences in yield become smaller, the Yield Spread is said to “narrow”; as the differences increase, it “widens.” The credit spread, also called the default premium, is one of the most popular Yield Spreads. The credit spread reflects the difference in yields between a lower- quality bond and a higher-quality bond of comparable maturity. For example, the credit spread is often derived as the YTM of a long-term Baa-rated bond index minus the YTM of a long-term T-bond index. The credit spread commonly widens during periods of economic uncertainty, when investors become more risk-averse, and it narrows during times of economic prosperity. Since the probability of default is greater during a recession, investors demand more of a premium. The credit spread widened substantially in 2008 dur-ing the financial crisis. In contrast, the spread narrowed gradually as the economy recovered in subsequent years. The spread in 2018 was especially low because even financially weak companies have a good chance of surviving and paying their debt obligations when economic growth is strong. Figure 17.2 shows the spread between 10-year Treasuries and Baa corporate bonds, a measure of the credit spread. In 2006 and 2007, the spread was relatively narrow averaging less than 2 percent, which reflected investor confidence in the economy.
- (Author)
- 2022(Publication Date)
- Wiley(Publisher)
As we will see later in the lesson, this empirical observation leads to the use of credit spread measure changes based on percentage as opposed to absolute credit spread changes for lower-rated issuers. 2.2 Credit Spread Measures b discuss the advantages and disadvantages of credit spread measures for spread-based fixed-income portfolios, and explain why option-adjusted spread is considered the most appropriate measure 2.2.1 Fixed-Rate Bond Credit Spread Measures The estimation of Yield Spreads from market information gives rise to several measures of the difference between a fixed-rate bond’s YTM and a benchmark rate. Recall that the YTM is an internal rate of return calculation of all bond cash flows that assumes any earlier payments are reinvested at the same rate and the bond is held to maturity. Spread comparisons are accurate when comparing bonds with identical maturities but different coupons. Because bond maturities vary in practice, a mismatch arises that creates measurement bias if the yield curve is sloped. As a bond rolls down the curve, the benchmark security can also change over time. Finally, yield-based measures do not accurately gauge the return of carry-based strategies often used by active managers (for example, long a risky bond, short a default risk-free position in the repo market). The Yield Spread (or benchmark spread) defined earlier as the simple difference between a bond’s YTM and the YTM of an on-the-run government bond of similar maturity is easy to calculate and interpret for option-free bonds, and it is particularly useful for infrequently traded bonds. The Yield Spread also facilitates the approximation of bond price changes for a given benchmark YTM change, assuming a constant Yield Spread. That said, this simple government bond–based measure has both curve slope and maturity mismatch biases and lacks consistency over time because government benchmarks change as a bond nears maturity.
eBook - PDFFixed Income Securities
Tools for Today's Markets
- Bruce Tuckman, Angel Serrat(Authors)
- 2022(Publication Date)
- Wiley(Publisher)
In the 20-year JNJ issue, for example, the spread of 75 basis points includes not only the credit risk of JNJ relative to the US Treasury, but also the difference between 20- and 30-year yields. Second, spreads of yields, even of the same maturity, inherit the weakness of yield described earlier and expressed as the coupon effect. Put another way, the Yield Spread between bonds of the same maturity can be misleading if their coupons are different and their underlying term structures have different shapes. Bond spreads are a more careful and more meaningful formulation of expressing price differences as a spread of rates. 4 To illustrate, consider again the US Treasury 7.625s of 11/15/2022. Table 1.3 derives discount fac- tors from a set of newly issued, benchmark Treasury bonds, which did not include the 7.625s of 11/15/2022. Table 1.4 then shows that the 111.3969 market price of the 7.625s of 11/15/2022 is 11.72 cents rich relative to its 111.2797 present value, which is computed using the discount factors derived from the benchmark bonds. The point of a bond spread is to express this 11.72 cents of richness as a spread of rates. Bond spreads can be com- puted relative to par, spot, or forward rates, but this section works with forward rates. The forward rates implied from the discount factors in Table 1.3 are 0.0154%, 0.1008%, and 0.1833%, for terms of 0.5, 1.0, and 1.5 years, respectively. Therefore, the 111.2797 present value of the 7.625s of 11/15/2022 is given by, 111.2797 = 3.8125 ( 1 + 0.0154% 2 ) + 3.8125 ( 1 + 0.0154% 2 ) ( 1 + 0.1008% 2 ) + 103.8125 ( 1 + 0.0154% 2 ) ( 1 + 0.1008% 2 ) ( 1 + 0.1833% 2 ) (3.13) 4 In the case of a bond with no embedded options, bond spreads are the same as option-adjusted spreads, which are described in Chapter 7.
eBook - PDFBonds
A Concise Guide for Investors
- M. Choudhry(Author)
- 2006(Publication Date)
- Palgrave Macmillan(Publisher)
The amount over 5.00 per cent at which the other bond trades is known as the spread. Therefore issuers of debt use the yield curve to price bonds and all other debt instruments. Generally the zero-coupon yield curve is used to price new issue securities, rather than the redemption yield curve (see later). Bonds 114 Acting as an indicator of future yield levels As I discuss later in this chapter, the yield curve assumes certain shapes in response to market expectations of future interest rates. Bond market participants analyse the present shape of the yield curve in an effort to determine the implications regarding the direction of market interest rates. This is perhaps one of the most important functions of the yield curve. Interpreting it is a mixture of art and science. The yield curve is scrutinised for its information content not just by bond traders and fund managers but also by corporate financiers as part of their project appraisal. Central banks and government treasury departments also analyse the yield curve for its information content, regarding not just forward interest rates but also infla- tion levels. They then use this information when setting interest rates for the whole country. (Or, in the case of the European Central Bank, for a whole continent. This illustrates the importance and relevance of the yield curve to us all.) Measuring and comparing returns across the maturity spectrum Portfolio managers use the yield curve to assess the relative value of invest- ments across the maturity spectrum. The yield curve indicates the returns that are available at different maturity points, and is therefore very important to fixed-interest fund managers, who can use it to assist them to assess which point of the curve offers the best return relative to other points. Indicating relative value between different bonds of similar maturity The yield curve can be analysed to indicate which bonds are ‘cheap’ or ‘dear’ (expensive) relative to the curve.
eBook - ePubTrading the Fixed Income, Inflation and Credit Markets
A Relative Value Guide
- Neil C. Schofield, Troy Bowler(Authors)
- 2011(Publication Date)
- Wiley(Publisher)
Over time, different measures of spread have evolved and to date there is no agreement over which measure is “right”. Our aim is to define each of the terms and perhaps identify those measures that are most popular.Consider the following bond:
According to Bloomberg's YAS screen, the following spread measures were being quoted in basis points:Issuer Ford Motor Credit Maturity 15 December 2016 Settlement 24 March 2011 Clean price 114.50 Yield to maturity 5.044% Spread over benchmark 208.50 basis points G-spread 268.50 I-spread 247.7 Basis −11.8 Z-spread 259.1 ASW 269.3 OAS 280.6 TED −251.3 Before we consider these measures in detail, Figure 5.11 provides a “big picture” overview of the issues and shows one simple way in which a bond yield could be decomposed.Figure 5.11 Decomposing a bond yield into its component parts.In simple terms, the foundation of a bond's return is the yield of a government security (“benchmark yield”) with the same maturity. The traditional “credit spread” is usually represented in two ways by systems such as Bloomberg. They may simply measure the difference in yield between the bond and a sovereign issue and a benchmark bond. This benchmark bond may have a very different maturity to that of the bond being analysed. To overcome this, it is possible to use the concept of the G-spread which is simply the difference between the yield to maturity of the bond and that of an interpolated government bond yield.5.3.2 Swap spreadsWe will argue later in the chapter that in certain markets the yields on government bonds may be impacted by a variety of non-economic factors and so over time practitioners have preferred to use interest rate swaps (“the swap rate”) as their benchmark pricing tool. As Figure 5.11
- Saied Simozar(Author)
- 2015(Publication Date)
- Wiley(Publisher)
Chapter 12 Credit Spreads In Section 5.3 we discussed the concept of spread relative to the TSIR. In this chapter we will quantify the meaning of Yield Spread and develop valuation, hedging and risk measurement methodologies for spread products. 12.1 EQUILIBRIUM CREDIT SPREAD So far, our analysis has focused on risk-free non-contingent cash flow bonds where our interpretation of non-contingency is related to embedded options in a bond. Thus, we did not include callable treasury bonds in our analysis, even though they are risk-free. We now turn attention to option-free or bullet risky assets and argue that, in an efficient market, Yield Spread is associated with default risk. The price of a risk-free asset with a cash flow of c at time t is, from (10.35), 12.1 We assume that investors are indifferent between the following two scenarios: A risk-free cash flow of ρ (t) at time t. A unit cash flow with a probability of ρ (t) and no cash flow with a probability of 1 – ρ (t) at time t. We can write the price p r of a risky bond as 12.2 where ρ (t) is the probability of no default or the survival probability by time t. If the expected instantaneous default rate η (t) is known at time t, the change in survival probability Δ ρ (t) between t and t + Δ t is given by 12.3 The negative sign in (12.3) signifies the decline of survival probability with time. The total survival probability can be calculated as 12.4 leading to 12.5 We now define the spot default rate of a credit security as the average probability of default in the period (0,t), such that 12.6 The definitions of spot default rate s s,c (t) and instantaneous default rate s f,c (t) or η(t) are analogous to the definitions of spot yield y (t) and instantaneous forward rate y f (t) in (2.27). The spot default rate is equal to the time average of the instantaneous default rates
eBook - ePubInterest Rate Markets
A Practical Approach to Fixed Income
- Siddhartha Jha(Author)
- 2011(Publication Date)
- Wiley(Publisher)
mostly trades below the swap yield.Before exploring the factors driving swap spreads, we first need to understand how to set up such a trade. To start with, we first need a reference Treasury bond, since swap rates can be found for any bond in question, given their continuous curve (see Chapter 5 on swaps). Suppose we pick a Treasury bond such as 2.375% Oct-14, that is, the 2.375% coupon bond maturing in October 31, 2014. The second component of the swap spread is the actual swap. Most commonly, we choose a swap also maturing on October 31, 2014. Suppose the yield on the bond is 2.36% and the swap yield is 2.76%. In this case, the swap spread is 0.4%, or 40 basis points (bps), with bps being the most common unit of quotation. To take a view on the spread, we buy one of the legs and sell the other. Recall that in the context of a swap, to buy is the same as to receive, while to sell is the same as to pay the fixed leg. Whether we buy or sell the Treasury leg (and vice versa for the swap leg) depends on whether we believe the spread is going to narrow or widen. A widening swap spread means the swap spread just described goes from 40 bp to, say, 45 bp. This implies that the swap yield rises a larger amount than the Treasury yield since the swap spread trade is swap yield – Treasury yield. Therefore:1. Widening swap spread = the swap yield rises more than the Treasury yield (or, falls less than the Treasury yield) = swap underperforms Treasury (remember, yield up = price down).2. Similarly, narrowing swap spread = swap yield falls more than Treasury yield (or rises less) = swap outperforms Treasury.Therefore, if we believe the swap market will underperform the Treasury market, we initiate wideners (aim for the 40 bp to rise). To position for a widener, we would pay in the swap and buy the Treasury bond. For the opposite view, we initiate narrowers (aim for 40 bp to fall) by receiving in the swap and selling the Treasury bond.
Available until 30 Nov |Learn more- (Author)
- 2019(Publication Date)
- Wiley(Publisher)
Credit spread measures also play an important role in the construction of credit portfolios and in investors’ expectations of portfolio risk and return. 3.1.1 Benchmark Spread and G-Spread A simple way to calculate a credit spread is to subtract the yield on a security with little or no credit risk (benchmark bond) from the yield on a credit security with a similar duration. This measure is called the benchmark spread. Typically, the benchmark bond is an on-the-run government bond. An on-the-run bond is defined as the most recently issued benchmark-size security of a particular maturity. 5 A problem with benchmark spread is the potential maturity mismatch between the credit security and the benchmark bond. Unless the benchmark yield curve is perfectly flat, using different benchmark bonds will produce different measures of credit spread. The G-spread is often used when the benchmark bond is a government bond. G-spread is the spread over an actual or interpolated government bond. When no government bond exists that has the same maturity as the credit security, a linear interpolation of the yields on two on-the-run government bonds is used as the benchmark rate. The yields of the two government bonds are usually weighted so that their weighted average maturity matches the credit security’s maturity. Simplicity is a key advantage of the G-spread: It is easy to calculate and understand, and different investors usually calculate it the same way. From a portfolio construction perspective, the G-spread is useful because the cal- culation indicates a way to hedge the credit securities’ interest rate risk. An investor can hedge the interest rate risk of a credit security by selling the duration-weighted amounts of the two benchmark government bonds out of his portfolio (or by selling them short if they are not owned). The G-spread is also useful for estimating yield and price changes for fixed-rate credit securities that do not have optionality.
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