What is a Yield Spread?
A yield spread is the difference between yields on two bonds, measured in basis points (1 bp = 0.01%). The most watched spreads are credit spreads (corporate bonds vs. government bonds) and term spreads (long-term vs. short-term government bonds). If a corporate bond yields 4.5% and a comparable government bond yields 3.0%, the credit spread is 150 basis points.
What Spreads Tell You
Credit spreads are a barometer of market risk sentiment. During economic confidence, spreads narrow as investors accept lower premiums for credit risk. During recessions or crises, spreads widen dramatically as investors demand compensation for rising default risk. In 2008, investment-grade spreads exploded from 100-150 bp to over 600 bp. Spread widening often precedes stock market declines, making it a valuable early warning indicator.
Investment Applications
Historically tight spreads suggest markets are underpricing risk, warranting caution. Extremely wide spreads may indicate oversold corporate bonds and potential buying opportunities, but only if the underlying companies remain solvent. Always verify that spread widening reflects market panic rather than genuine deterioration in credit quality before treating it as a buying signal.