What is a high yield bond spread?
A high-yield bond spread is the percentage difference of the current yields of various categories of high-yield bonds compared to high-quality corporate bonds, treasury bills or other benchmark bond measure. Differences are often expressed as a difference in percentage points or in basis points. The high yield bond spread is also called the credit spread.
Key points to remember
- A high-yield bond spread, also called a credit spread, is the difference between the yield on high-yield bonds and a benchmark bond measure, such as high-quality bonds or treasury bonds.
- High yield bonds offer higher yields due to the risk of default. The higher the risk of default, the higher the interest paid on these bonds.
- High-yield bond spreads are used to assess credit markets, where widening spreads may signal a weakening of macroeconomic conditions.
How a high-yield bond spread works
A high yield bond, also known as an unwanted bond, is a type of bond that offers a high interest rate due to its high risk of default. A high-yield bond has a lower credit rating than government bonds or higher-quality corporate bonds, but the interest income or higher yield attracts investors. The high yield sector has a low correlation with other fixed income sectors and is less sensitive to interest rates, making it a good investment asset for portfolio diversification.
The greater the risk of default on an unwanted bond, the higher the interest rate. One measure that investors use to assess the level of risk inherent in a high yield bond is the spread of high yield bonds. The spread on high yield bonds is the difference between the yield on low quality bonds and the yield on stable high quality bonds or government bonds of similar maturity.
As the spread increases, the perceived risk of investing in an unwanted bond also increases and, therefore, the potential to earn a higher return on these bonds increases. The spread on higher yielding bonds is therefore a risk premium. Investors will assume the higher risk prevailing in these bonds in exchange for a premium or higher earnings.
High yield bonds are generally valued based on the difference between their yield and the yield on US Treasury bonds. A company with poor financial health will have a relatively high spread against treasury bills. This contrasts with a financially healthy company that will have a small spread against US Treasuries. If Treasury bills yield 2.5% and lower quality bonds yield 6.5%, the credit spread is 4%. Since the spreads are expressed in basis points, the spread in this case is 400 basis points.
The spreads on high yield bonds, wider than the historical average, suggest a higher credit and default risk for unwanted bonds.
Benefits of high yield bond spreads
High yield spreads are used by investors and market analysts to assess all credit markets. The variation in the perceived credit risk of a company involves a credit spread risk. For example, if falling oil prices in the economy negatively affect a wide range of businesses, the high yield spread or credit spread is expected to widen, with yields rising and prices falling. .
If the general market risk tolerance is low and investors are moving towards stable investments, the spread will widen. Higher spreads indicate a higher risk of default on junk bonds and may reflect the overall business economy (and therefore credit quality) and / or a broader weakening of macroeconomic conditions.
The high yield bond spread is most useful in a historical context, as investors want to know how close the spread is today compared to average spreads in the past. If the spread is too narrow today, many savvy investors will avoid buying junk bonds. High yield investments are attractive vehicles for investors if the spread is wider than the historical average.