Quick Answer: How Do Bond Spreads Work?

Why do bond spreads tighten?

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..

How do credit spreads affect bond prices?

How Changes in the Credit Spread Affect the Corporate Bondholder. … This, in turn, drives up the price of the bondholder’s corporate bond. On the other hand, rising interest rates and a widening of the credit spread work against the bondholder by causing a higher yield to maturity and a lower bond price.

What is the credit spread on the BBB bonds?

Historically, the average credit spread between 2-year BBB-rated corporate bonds and 2-year U.S. Treasuries is 2%. The current yield on a 2-year BBB-rated corporate bond is 5% while the current yield on a 2-year U.S. Treasury is 2%.

Why do credit spreads widen?

Credit spreads widen when market participants favor government bonds over corporate bonds, typically when economic conditions are expected to deteriorate. In 2018 credit spreads widened globally and reached a two year high on investor expectation of a slowdown in economic growth.

Why do credit spreads rise during financial crisis?

Credit spreads measure the difference between interest rates on corporate bonds and treasury bonds with similar maturity that have no default risk. Rise during financial crisis to reflect asymmetric information problems that make it harder to judge the riskiness of corporate borrowers.

How do you calculate the spread?

The calculation for a yield spread is essentially the same as for a bid-ask spread – simply subtract one yield from the other. For example, if the market rate for a five-year CD is 5% and the rate for a one-year CD is 2%, the spread is the difference between them, or 3%.

What is yield to maturity of a bond?

Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. … In other words, it is the internal rate of return (IRR) of an investment in a bond if the investor holds the bond until maturity, with all payments made as scheduled and reinvested at the same rate.

What does a bond yield mean?

Bond yield is the return an investor realizes on a bond. The bond yield can be defined in different ways. Setting the bond yield equal to its coupon rate is the simplest definition. … More complex calculations of a bond’s yield will account for the time value of money and compounding interest payments.

What is spread duration?

Spread duration is the sensitivity of the price of a security to changes in its credit spread. The credit spread is the difference between the yield of a security and the yield of a benchmark rate, such as a cash interest rate or government bond yield.

Why are bond spreads important?

Bond spreads are the common way that market participants compare the value of one bond to another, much like “price-earnings ratios” are used for equities. Bond spreads reflect the relative risks of the bonds being compared. The higher the spread, the higher the risk usually is.

What do credit spreads tell us?

A credit spread is the difference in yield between a U.S. Treasury bond and another debt security of the same maturity but different credit quality. … Credit spreads are also referred to as “bond spreads” or “default spreads.” Credit spread allows a comparison between a corporate bond and a risk-free alternative.

What does a high credit spread mean?

A credit spread is the difference in yield between two bonds of similar maturity but different credit quality. … Widening credit spreads indicate growing concern about the ability of corporate (and other private) borrowers to service their debt. Narrowing credit spreads indicate improving private creditworthiness.

Which bonds have the widest credit spreads?

Except for when the market was broken in 2008, corporate bonds are trading at their widest credit spreads and lowest dollar prices over the past 20 years.

What is spread risk of bonds?

Spread risk refers to the danger that the interest rate on a loan or bond turns out to be too low relative to an investment with a lower default risk for it to be a good use of funds.

What is the spread on a bond?

The bond spread or yield spread, refers to the difference in the yield on two different bonds or two classes of bonds. Investors use the spread as in indication of the relative pricing or valuation of a bond. … The wider the spread between two bonds, or two classes of bonds, the greater the valuation differential.

How do you calculate bond spread?

Subtract the lower interest rate from the higher interest rate. That will be the bond spread. This measurement is also called the yield spread. Yield spread can also be calculated between other debt securities, such as certificates of deposit.