Yield Spread: Definition, How It Works, and Types

Definition

A yield spread is the difference between the yields of two debt instruments. It’s usually expressed in percentage points or basis points (1% = 100 basis points). Spreads compare bonds that differ by issuer, credit quality, maturity, or embedded options.

How it’s calculated

• Subtract one bond’s yield from the other’s yield.
• Example: A bond yielding 7% and another yielding 4% have a spread of 3 percentage points, or 300 basis points.
• Spreads are commonly quoted relative to U.S. Treasury yields (the benchmark) — this specific comparison is often called the credit spread.

Why yield spreads matter

• Risk signal: Wider spreads generally indicate higher perceived credit, default, liquidity, or economic risk; narrower spreads imply lower perceived risk.
• Pricing and relative value: Investors use spreads to judge whether a bond is cheap or expensive relative to benchmarks or peers.
• Economic insight: Changes in spreads and the overall yield curve can signal expectations for growth, inflation, or recession (e.g., widening spreads and a steeper curve often indicate expectations of stronger growth; a flattening or inversion can signal slowdown or recession).

Common types of spreads

Zero-Volatility Spread (Z‑Spread)
– Measures the constant spread added to the Treasury spot-rate curve that makes the present value of a bond’s cash flows equal to its market price.
– Useful for bonds without embedded options; calculation can be iterative and computationally intensive.

Option‑Adjusted Spread (OAS)
– Adjusts the spread for the value and impact of embedded options (callable or puttable features).
– Accounts for interest-rate volatility and the option’s effect on expected cash flows; commonly used for mortgage-backed securities and callable bonds.

High‑Yield Bond Spread
– The yield difference between non-investment-grade (junk) bonds and a benchmark (e.g., Treasuries or AAA corporates).
– Wider-than-normal high-yield spreads signal elevated default risk or deteriorating market sentiment.

Term Spread vs. Yield Spread

• Term spread: Difference in yields between bonds of different maturities but similar credit quality (e.g., 2‑year vs. 10‑year Treasuries). It reflects expectations for future interest rates, growth, and inflation.
• Yield/credit spread: Emphasizes differences in credit risk, issuer characteristics, or embedded features rather than maturity.
• Both are used together to assess market conditions: term spreads show macro interest-rate expectations; credit spreads show credit and liquidity sentiment.

Swap Spread

• The swap spread is the difference between a fixed rate on an interest-rate swap and the yield on a government bond of similar maturity.
• It reflects credit and liquidity considerations specific to the swap and interbank markets. A widening swap spread can indicate increased perceived credit or liquidity risk in the financial system.

Practical examples

• If a high-yield index yield increases from 7.0% to 7.5% while the 10‑year Treasury remains at 2.0%, the spread widens from 500 bps to 550 bps — indicating relative underperformance of high-yield vs. Treasuries.
• A corporate bond yielding 4.5% versus a 10‑year Treasury at 2.0% has a credit spread of 250 basis points.

Special note: Yield Spread Premium

• In mortgage lending, a yield spread premium is a payment to a broker from a lender when the broker places a borrower into an interest rate higher than the lender’s par rate. It’s a form of broker compensation, not a spread between securities.

Key takeaways

• Yield spread = difference between two yields, usually expressed in basis points.
• Spreads provide insight into relative risk, liquidity, and market sentiment.
• Types include Z‑spread, OAS, high‑yield spreads, term spreads, and swap spreads—each illuminates different risks or market features.
• Widening spreads typically signal rising perceived risk; narrowing spreads typically signal improving conditions.

Bottom line

Yield spreads are a fundamental tool for fixed-income investors and analysts. They quantify relative value and risk across issuers, maturities, and structures, and movements in spreads offer early signals about credit conditions and broader economic expectations.