Yield Spreads: Demystified

This story is a continuation in a series on simplifying Bond Investing terminologies. If you'd like to know more about YTM (Yield to Maturity) and its relevance to Bond Investing, here's a fairly simple explanation:

Another commonly heard Bond Investing term is "Yield Spread", used interchangeably with the term "Credit Spread". The simplest definition of Yield Spread is - the difference in YTM (Yield to Maturity) between a particular bond, and a sovereign bond of a similar maturity.

A rather oversimplified example will help you understand this better. Let's assume that a 7 per cent, 1000 rupee face value treasury bond with a maturity that's 1 year from today is trading at Rs. 980. A year from today, you're set to earn Rs. 90 on your investment of Rs. 980 - a YTM of 9.18 per cent.

At the same time, let's say that a 1-year maturity, 8 per cent coupon, AAA rated bond trades at Rs. 970 today. This implies that you stand to gain Rs. 110 on an investment of Rs. 970, if you were to purchase this bond today and hold it until maturity (and the issuer doesn't default!) - a YTM of 11.34 per cent. In this case, the yield spread for the AAA rated bond is 11.34 per cent minus 9.18 per cent, or 2.15 per cent.

Intuitively, the yield spread for a lower rated bond will be more than that of a higher rated bond, because investors will demand a premium in exchange of taking on the additional default risk associated with a lower rated bond.

Here's an interesting question: if the yield spread for AAA's is 2.15% today, will it remain constant at this number? The answer is no, as a multitude of factors will influence it.

First, the creditworthiness of companies improves and declines, based on several factors. For instance, the creditworthiness of real estate companies as a collective group was fairly good until 2010. However, the mismatch between oversupply and muted demand, coupled with a slowdown in retail borrowing, has led to a glut of unsold inventory for real estate companies in recent times. As a result, the default risk associated with their bonds has gone up vastly. To factor in this increased risk, bond investors would demand a higher return, and hence the bond prices of these companies would fall; leading to a higher YTM and a widening yield spread.

Second, the quantum of supply of bonds of a certain credit profile influences their prices. In September '16, the value of outstanding corporate bonds in India stood at $ 300 Billion. Recent reports have indicated that this may rise to $500 Billion in another three years - this could lead to a gradual widening in yield spreads, as the market is flooded with new issues. When banks become more circumspect with respect to lending to corporations of a particular credit profile (due to regulation or simply due to risk aversion), these companies have no option other than to issue bonds to fulfill their requirements. In such a scenario, the supply of a bonds of that credit profile increases greatly, thereby leading to a rise in their yields - and a corresponding widening of the yield gap.

Similarly, a narrowing of yield spreads implies that the market is factoring in a lower default risk in the category of bonds that have the lower credit rating, presumably due to improving macros.

Debt fund managers are saddled with the complex task of evaluating the near and medium term future of the debt markets; by comparing yields, maturities, demand & supply, and liquidities of debt securities across the borrowing spectrum, and drawing out patterns to figure out (among other things) where opportunities to cash in on future shrinkages in yield gaps lie.

For the average retail investor with a paucity of time and information, debt mutual funds are the way to go. A qualified Financial Advisor can help you pick the most suitable category at any time, after a top-level evaluation of fixed income market trends.