Definition: The yield spread, also known as the credit spread, is the difference between the yields of two investments in terms of credit quality and the risk of investing in one debt instrument instead of another instrument.
What Does Yield Spread Mean?
What is the definition of yield spread? The yield spread is measured in basis points (bps) and enables bond investors to compare the yield, maturity, liquidity and solvency of two debt instruments. For instance, the yield of a municipal bond is 7.50%, and the yield of a corporate bond is 8.50%.
The difference between the two yields is: 8.50% – 7.50% = 1% or 100 basis points (one basis point = 0.01%). However, a corporate bond is riskier and has a shorter maturity that a municipal bond. All these factors are taken into consideration when comparing one security over another using the yield spread.
Let’s look at an example.
Example
An investor holds a diversified bond portfolio and wants to calculate the yield spread between similar bonds. He constructs the following table to calculate the yield spread:
The yield on the 5-year Treasury bond is 5.25% while the yield on the 25-year Treasury bond is 6.25%. The yield spread between the two comparable debt instruments is 100 basis points. Considering the historical yield spread of 85 bps, the 5-year Treasury bond should yield 4.40%; therefore, its current yield of 5.25% is higher.
Generally, the goal of an investor is to compare current yields while considering the historical yield spread to determine the relationship between different debt instruments. Given the table above, the corporate bonds are trading higher than all other types of bonds in this portfolio, meaning that technology corporate bonds are riskier than other types of bonds. On the other hand, the spread between the current yield spread and the historical yield spread is only 190 bps, which means that investors today believe that technology bonds are not as risky as their historical yield spread implies.
Summary Definition
Define Yield Spread: Yield spread is the difference between two debt instruments’ yields when each have different maturities, credit ratings, and risk.
