What it is:
Yield spread is the difference in yield between two securities or, more commonly, two classes of securities.
How it works (Example):
Let's assume thatX is yielding 5% and Y is yielding 7%. The yield spread is 2%.
Spreads are generally described in "basis points," which is abbreviated "bps" and pronounced "beeps." One percentage point is equal to 100 bps. In the example above, a bond trader would say that the yield spread between the two bonds is "200 beeps."
Yield spreads help investors identify opportunities. The goal is to take advantage of expected changes in yield spreads between or among certain sectors of the bond market. To illustrate, consider the following table, which compares bond yields of various sectors to U.S. Treasuries:
The task for any bond trader is to determine how prices and yields on securities move relative to each other. In this example, healthcare bonds are trading at a higher yield spread than AAA corporate bonds, meaning there is something about healthcare bonds that makes investors think they are risker than AAA corporate bonds. But healthcare bonds are trading at a yield spread lower than their historical average (250 bps vs. 400 bps), which indicates that traders think healthcare bonds are less risky today than their historical average would indicate.
Why it Matters:
Ultimately, when an investor using this strategy believes the yield spread between two sectors is out of line, he or she either buys or sells securities in those sectors (depending on whether the spread is too narrow or too wide) as a way to earn an extra return when the sectors eventually realign.
In the example above, investors might notice that the spreads on high-yield bonds and bonds from the healthcare industry are especially low (a 375-point spread for high yield bonds versus the usual 500-point spread and the 250-point spread for healthcare bonds versus the usual 400-point spread), so they may want to put off purchasing either type of bond until spreads widen out to their historical norms. Bond traders generally want to buy when yield spreads are at their widest and sell when they are at their narrowest.