The difference in yield between two investments is also known as the yield spread. Bond investors look at yield spreads in order to compare bonds with different maturities and credit risk.
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Yield Spread Example
To illustrate, a 10-year corporate bond might have a yield of 5% and 2 year corporate bond a yield of 2%. In this example the yield spread is 3%. Similarly a 10 year corporate bond with a high credit rating might have a yield of 4%, while a 10 year corporate bond with a low credit rating might have a yield of 6%. In this case the yield spread is 2%.
In addition to looking at yield spreads to compare two different bonds, investors will also look at the yield spread between different categories of bonds in order to gauge how the market is currently viewing risk and the potential for economic growth.
When the market expects the economy to do poorly in the future, yield spreads between junk and investment grade bonds will normally widen as investors require a higher return for the greater risk they perceive to be on the horizon. Similarly when yield spreads between junk and investment grade bonds contract this is generally an indication that investors are more comfortable with taking risks and are expecting economic growth to accelerate.
Making use of historical spreads is also useful while making an analysis of potential opportunities for investments. Trends between two bonds can be predicted or at least better understood by comparing yield spreads over the years.
You can learn more about how to profit from the yield spread here.
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