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Yield Spread

February 21, 2010

What is Yield ?

The term yield indicates the amount in cash that the owners of a security will get. Generally,  it does not take into account the price variations, at the difference of the total return. Yield applies to various stated rates of return on stocks (common,  preferred, and convertible), fixed income instruments like bonds, notes, bills, strips, zero coupon etc.  and other investment insurance products like annuities.

What is Yield spread ?

Yield spread is the difference between the quoted rates of return on two different investments, usually of different credit quality.

The “yield spread of X over Y” is simply the percentage return on investment (ROI) from financial instrument X minus the percentage return on investment from financial instrument Y (per annum).It is an indication of the risk premium for investing in one investment product over another.
The higher the yield spread, the greater the difference between the yields offered by each instrument.

Implications:

When spreads widen between bonds with different quality ratings it implies that the market is factoring more risk of default on lower grade bonds. For example, if a risk free 10 year Treasury note is currently yielding 5% while junk bonds with the same duration are averaging 7%, the spread between Treasuries and junk bonds is 2%.
If that spread widens to 4% (increasing the junk bond yield to 9%), the market is forecasting a greater risk of default which implies a slowing economy. A narrowing of spreads (between bonds of different risk ratings) implies that the market is factoring in less risk.

There are several measures of yield spread, including Z-spread and option-adjusted spread.

Here is a news article related to the same:
Greek/German yield spread widens, Greek CDS rises

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