By Kevin FitzGerald
I’ve seen a number of references to the term "yield spread." This term seems to relate to current events in the bond market as well as to the actions taken by the Federal Reserve. Could you explain this in more detail for me?
S.F., Fort Lee, N.J.
The first thing to realize is that different types of bonds (whether municipals, investment grade corporate bonds or even high-yield bonds) don’t trade in a vacuum. Rather they are related to each other in terms of differences in yield. In simple terms, the current yield on any bond is equal to the income from the bond divided by the price of the bond. The result of this calculation is then multiplied by 100 to get it expressed in percentage terms. The term spread relates to measuring the differences in yield between different types of bonds.
Unlike stocks, whose prices are readily available, movements in bonds aren’t as easy to follow. Therefore, we look at yield spreads between various types of bonds to get a clue as to what the bond market is "thinking." Due to the higher degree of risk, high-yield bonds generally carry higher yields than a treasury bond of the same maturity. One gauge of the degree of market nervousness is the widening of the historical rate spread between treasury bonds and high yield bonds. As reported in the New York Times on Oct. 15 (after the Fed cut rates for the second time), the estimated yield on the Solomon Smith Barney index of high-yield bonds exceeded that to Treasuries by 6.82 percentage points, compared with a 5.3 point spread before the cut. It took some time for the market to digest the rate cut –10 days later, The Wall Street Journal reported that the spread between high-yield bonds and treasuries had fallen to 6.04 percentage points.
In strong economic times, the yield spread between high yield bonds and treasuries narrows as market participants feel comfortable buying high-yield securities thereby bidding up their prices and lowering the yield bringing them closer to the yield of treasuries. During times of economic uncertainty, a "flight to quality" may take place where market participants sell off their holdings of high yield bonds and bid up the prices of treasury bonds, thereby lowering the yield on treasuries and increasing the yield of high yield bonds. This action widens the yield spread between high-yield and treasury bonds. Therefore, the measurement of yield spread is a gauge of the perceived risk in the fixed income market. This risk in most cases is driven by the fear of inflation or (as seems to be the case currently) the fear of economic slowdown.
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The flight to quality discussed above, relates to risk. As recently discussed in Business Week (Nov. 2), there has also been a recent "flight to liquidity," which relates to uncertainty. In this latter case, yield spreads are measuring the difference in yield between the 30-year and 6-month treasuries. Uncertainty is seen by the preference for the shorter term 6-month treasury.
These shorter term treasury securities are more in demand and therefore easier to sell marking them more liquid. This liquidity preference shows up in the widening yield spread which is caused by bidding up the shorter term treasury and thereby reducing its yield relative to the longer term bond.
As pointed out by Business Week, this widening yield spread raises the cost of longer term borrowing because those rates are in part tied to the yields on treasuries. Higher borrowing rates have the effect of squeezing out some borrowers thereby creating a "credit crunch" which could further slow down the domestic economy. Business Week noted that he Federal Reserve’s reduction in interest rates on October 15th in part sought to reduce the potential for a credit crunch.
The fixed-income markets will be seen to begin to return to "normal" when the yield spreads on high-yield bonds vs. treasuries and the yield spreads within the treasury market realign themselves closer to their historical spread relationships.
The information contained herein has been obtained from sources believed to be reliable, but we cannot guarantee its accuracy or completeness. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security.
Kevin FitzGerald is First Vice President-Investments at Paine Webber. He focuses on the areas of professional money management, asset allocation and retirement planning. He can be reached at 1 (800) 654-6162, ext. 448.