Yield Spreads

Understanding Yield Spreads | CFA Level I Fixed Income

In this lesson, we will explore various yield spread measures, which can be divided into two main categories: yield spreads over benchmark rates and yield spreads over the benchmark yield curve.

Yield-to-Maturity Components: Benchmark and Spread

To comprehend changes in bond prices and yields-to-maturity, it’s crucial to break down a bond’s yield-to-maturity into two components:

  1. Benchmark yield: Often a government bond yield, this serves as the base rate.
  2. Spread: The difference between the yield-to-maturity and the benchmark yield.

This separation is important for distinguishing between macroeconomic and microeconomic factors affecting bond prices and yields-to-maturity.

Macroeconomic Factors

These primarily impact the benchmark rate and include:

  • Expected inflation rate
  • General economic growth and the business cycle
  • Foreign exchange rates
  • Monetary and fiscal policy

Microeconomic Factors

These factors are specific to the bond itself and affect the spread:

It’s worth noting that general yield spreads across issuers can widen and narrow due to changes in macroeconomic factors.

Building Blocks of a Bond’s Yield

The following factors contribute to a bond’s yield:

  1. Real return: Derived from economic growth, currency strength, and monetary and fiscal policy.
  2. Inflation premium: Compensates the investor for the effects of inflation.
  3. Real return + Inflation premium: This makes up the benchmark rate or risk-free rate of return.
  4. Tax premium: Compensates the investor for any tax impact of holding the bond.
  5. Liquidity premium: Compensates the investor for higher bid-ask spreads.
  6. Credit risk premium: Compensates for the likelihood of a default.

The last three premiums are responsible for the spread over the benchmark, collectively known as the risk premium.

EXAMPLE

Which of the following scenarios is likely to cause the yield spread of a corporate bond to increase?

  1. A financial crisis
  2. The issuer’s debt level doubled in the past year
  3. Central bank increases interest rates

Answers:

  1. A financial crisis is a macroeconomic event that affects the benchmark rate and may cause the yield spread to increase as investors demand a higher risk premium.
  2. Increasing debt levels lower a company’s credit quality and are likely to cause the yield spread to widen.
  3. An increase in interest rates by the central bank is a macroeconomic factor that can increase benchmark yields. The effect on spreads is not as clear. In the long term, higher rates may increase a company’s borrowing costs, which can lower its credit quality and potentially cause the yield spread to widen.

Different Types of Yield Spreads

When discussing yield spreads, it’s essential to mention various types:

  • Benchmark spread: When a specific benchmark bond is named.
  • G-spread: When the benchmark is a government bond or interpolated government bond yield.
  • I-spread: When the benchmark is a swap rate.

Spreads are usually measured in basis points (bps), where one basis point is a hundredth of a percent (0.01%).

G-Spread Calculation

To calculate a G-spread, interpolation can be used if no benchmark exists for a specific bond’s tenor or if a bond has an unusual maturity. For example:

  • A corporate bond with 3.2 years to maturity and a 5.48% yield-to-maturity
  • Interpolated yield (using T-notes with 3 and 3.5 years to maturity) is 2.34%
  • G-spread is 3.14%

I-Spread Calculation

I-spreads are frequently used for bonds denominated in euros. For example:

  • A newly issued 3-year euro-denominated bond priced relative to the 3-year euro swap rate
  • I-spread of 120 basis points

Zero-Volatility Spread (Z-Spread) and Option-Adjusted Spread (OAS)

The Z-spread accounts for the shape of the yield curve by adding an equal spread to each benchmark spot rate. It can be calculated through trial and error or with a computer. The option-adjusted spread (OAS) can be derived from the Z-spread for bonds with embedded options. For a callable bond, the value of the embedded call option (in basis points per year) is subtracted from the Z-spread.

In summary, the Z-spread is the spread for the callable bond, while the OAS represents the spread for an equivalent straight bond. Bondholders of the callable bond receive a higher yield as compensation for the call option.

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