Yield spread

In finance, the yield spread or credit spread is the difference between the quoted rates of return on two different investments, usually of different credit quality. It is often an indication of the risk premium for investing in one investment product over another.[1] The phrase is a compound of yield and spread.

The "yield spread of X over Y" is generally the annualized percentage return on investment (ROI) of financial instrument X minus the ROI of financial instrument Y.

There are several measures of yield spread relative to a benchmark yield curve, including interpolated spread (I-spread), zero-volatility spread (Z-spread), and option-adjusted spread (OAS).

Yield spread analysis

Yield spread analysis involves comparing the yield, maturity, liquidity and creditworthiness of two instruments, or of one security relative to a benchmark, and tracking how particular patterns vary over time.

When yield spreads widen between bond categories with different credit ratings, all else equal, it implies that the market is factoring more risk of default on the lower-grade bonds.[1] For example, if a risk-free 10-year Treasury note is currently yielding 5% while junk bonds with the same duration are averaging 7%, then the spread between Treasuries and junk bonds is 2%. If that spread widens to 4% (increasing the junk bond yield to 9%), then the market is forecasting a greater risk of default, which implies a slowing economy. A narrowing of yield spreads (between bonds of different risk ratings) implies that the market is factoring in less risk, due to an expanding economy.

Consumer loans

Yield spread can also be an indicator of profitability for a lender providing a loan to an individual borrower. For consumer loans, particularly home mortgages, an important yield spread is the difference between the interest rate actually paid by the borrower on a particular loan and the (lower) interest rate that the borrower's credit would allow that borrower to pay. For example, if a borrower's credit is good enough to qualify for a loan at 5% interest rate but accepts a loan at 6%, then the extra 1% yield spread (with the same credit risk) translates into additional profit for the lender. As a business strategy, lenders typically offer yield spread premiums to brokers who identify borrowers willing to pay higher yield spreads.

See also

Notes

  1. 1 2 Michael Simkovic, Benjamin Kaminetzky (2011), "Leveraged Buyout Bankruptcies, the Problem of Hindsight Bias, and the Credit Default Swap Solution", Columbia Business Law Review, Vol. 2011, No. 1, p. 118.
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