Yield is used to calculate the return, or in the case of fixed income products, the income from an investment as a percentage of the initial amount invested (income / investment amount x 100). Yield calculations are used by investors to determine the attractiveness of a bond or a similar product that pays a coupon.
The yield spread is the difference in yield between a bond yield and the risk-free rate (a notional rate offered by an investment with the lowest level of risk), or between two comparable assets. The spread is equivalent to the risk differential between each investment. Expressed as a percentage or in basis points (where 1% is 100 basis points), this will be quoted in market information where two instruments are compared. While the yield spread does not always appear on mutual fund performance information, the fund manager may refer to it in his or her reports as a value or economic indicator.
Yield Spread Illustration
|Fixed income instrument||Yield||Risk free rate||Yield spread*|
|Government 10-year Treasury||7%||5%||2%|
|Corporate 3-month Bond||9%||5%||4%|
|Corporate 5-year Bond||4%||5%||-1%|
|Gilt fund (a mutual fund scheme investing in government securities)||7%||5%||2%|
|Income fund (a mutual fund scheme investing in debt securities)||7%||5%||2%|
*Yield spread between risk-free rate and instrument
In this illustration, the yield spreads which show a positive differential between the risk-free rate and the investment product are those which are deemed marginally riskier or show higher returns than the risk-free rate. In general, investors will look to exploit differences in the usual yield spread, so – for example – if the Government 10-year Treasury is currently showing a yield spread of 2% where normally it shows 1%, an investor may regard this as a buying/selling opportunity. However, it is important to research the reasons for any change in yield spread (change in interest rate movements or other macroeconomic indicators), before concluding that the bonds are indeed cheap and represent good value or vice versa.
When do we use yield spread?
In general, a fund manager will use yield spread in order to assess which investments are the most attractive. For example, if historical yield spreads between a particular bond and the risk-free rate are very different from the current valuations, there may be a buying/selling opportunity. Yield spread can also highlight value, or which bonds are “cheap”/ “expensive”. Generally speaking, those investments with higher yield spreads are also riskier, as investors require a better return for riskier products.
Yield spread can also affect foreign currency trades. If a particular yield spread highlights attractive sovereign debt in a particular region, investors will move money to that country, thereby triggering strength in that local currenc