One is the yield-curve which is what you described. If you plot all the sovereign debt (of a single country) with yield on the Y axis and time to maturity on the X axis, the graph will normally curve upwards- people want to be compensated for putting their money away longer. This isn't always necessarily the case though for several reasons.
For one, if inflation is high now but is expected to fall (like in the early 80s) the short-term notes might have a high rate whereas long-term notes have a lower rate since inflation is expected to decrease.
Also, if interest rates are expected to decrease that will be taken into account. There's also supply & demand forces (if the stock market is doing exceptionally well fewer people will invest in sovereign debt which will push the yields up).
So that's the first kind of spread. The other kind is what's called a "default spread".
If you look on your credit card statement it will typically say something along the lines of "interest rate of LIBOR + 8%"- that 8% is the default spread.
It's essentially the amount the market charges for a firm in order for investors to risk their money with the debt.
For example, if LIBOR is 2% and a large firm has AAA debt its default spread will likely be .75% (75 basis points). Therefore when they issue debt they'll pay 2.75% interest on it. A junk bond (rated BB or lower) typically has a 10%+ yield spread (ccc avg spread was 14% earlier this year), so they might pay 16% to borrow based on default spread.
I hope that helps-- and welcome to finance.
The answer depends on your point of view. If you are a bond buyer, you want high yields. A buyer wants to pay $800 for the $1,000 bond, which gives the bond a high yield of 12.5%. On the other hand, if you already own a bond, you've locked in your interest rate, so you hope the price of the bond goes up. This way you can cash out by selling your bond in the future.
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If the five-year Treasury bond is at 5% and the 30-year Treasury bond is at 6%, the yield spread between the two debt instruments is 1% (6% - 5%). If the yield spread has historically been closer to 5%, the investor is much more likely to invest in the five-year bond compared to the 30-year bond (as it should be trading around 1% instead of 6%).
In theory, bond traders and analysts will look at these bond spreads and attempt to use it to determine whether the Fed will raise, lower, or hold steady the Discount Rate which, in turn, will influence the Fed Funds Rate and the rate of all interest rates in the economy. The bigger the threat of inflation, the bigger the spread, and therefore, the thinking goes, the more likely interest rates will rise. This will, in turn, cause bond prices to fall. In such a scenario, an investor might conceivably cut his or her bond holdings, instead sitting on the sidelines with cash, short-term TIPs, or equities depending upon the situation.
High-yield spreads are used to evaluate the overall credit markets. Higher spreads indicate a higher default risk in junk bonds, and can be a reflection of the overall corporate economy (and therefore credit quality) and/or a weakening of economic conditions.
The spreads of both the five- and 10-year bond yields can be used to gauge currencies. The genereal rule is that when the yield spread widens in favor of a certain currency, that currency will appreciate against other currencies.
Many traders monitor bond spreads for indications or expectations for changes in interest rates. Also, the retail spread on exchange rates can offset any additional yield they are seeking.
I would add to Patrick's otherwise excellent answer that bond spreads are not just about default and tenor, but about liquidity, optionality, seniority, recovery after default, market sector, taxation, convexity, etc, etc, etc so there are really more than 2 kinds of spreads...
If spread rises it is because of uncertain economic times. In other words people run to the safer bonds, resulting in lower prices on lower grade bonds.
So I am reading financial papers (to make myself look smart) and keep finding the word bond spreads inside. I know that Bond spreads is the difference between a 10 Year bond yield, lets say, and a 5 Year old bond yield.
What I dont know is why are spreads important?
And why is t bad when the spreads rise?
Could you explain? Maybe provide an example or something..
Thank you!:)
