What is the yield spread?
The yield spread
is the difference in interest rates (yields) offered by different bonds
. It also works with other debt securities.
You could use the yield spread is you wanted to compared bonds that have different credit ratings, different maturities or are from different countries.
Using the yield spread allows you to assess whether a particular bond is a decent investment option. By using the yield spread between two bonds, you can weigh up how risky they are.
Let’s see how it works with the help of an example…
How to use the yield spread
You decide to compare the yield spread of two different government bonds:
A ten-year German government bond with a yield of 0.4%; and
A ten-year Greek government bond with a yield of 10%.
The yield spread between these two bonds is 9.6% (or 960 basis points). This shows you the Greek bond is much more risky than its German counterpart.
This is because Greece is struggling with a much weaker economy that Germany. And the Greek government has much more debt.
In other words, there’s a higher chance the Greek government won’t pay the interest on the bond or repay the original bond amount.
Add to that the current financial goings on in Greece and you can see why it’s looking like a risky investment.
So for Greece to attract investors to buy its bonds, it has to compensate for this by offering a much higher interest rate than Germany.
Professional bond investors use yield spreads to watch for signs of economic distress. And as a way to check if a bond is looking cheap or expensive.
So there you have it. How to weigh up your options if you want to invest in bonds.
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