Yield Spread Definition
Debt instruments with different characteristics, such as maturity date or credit/risk rating, generally have different yields. The yield spread is the difference between yields on these instruments. When the yield on a two-year treasury bond is 3%, and the yield on a 30-year treasury bond is 5%, there is a 2% yield spread.
The historical data on yield spread is a great indicator of investor sentiment. It can also be used in assessing the current value of debt instruments.
A Little More on What is Yield Spread
The yield spread on US treasuries is used as a benchmark to compare the other securities with a similar maturity date. Generally, higher-risk assets have a larger yield spread. It follows the general concept that investors expect higher reward for greater risk.
An increase in the yield spread can reflect a change in comparable performance between the industries. If the yield on a high-yield corporate bond class moves up .5% and the comparable 10-year treasury bond rate remands the same, this can show that the class of corporate bonds underperformed the treasuries.
Comparison of current and historical yield spreads gives an indication of how investors see current economic conditions. Contracting yield spreads tend to lead toward a flattening yield curve; conversely, widening yield spreads tend to indicate stable economic conditions and a normal yield curve.
References for Yield Spread
Academic Research on Yield Spread
- · How much of the corporate-treasury yield spread is due to credit risk?, Huang, J. Z., & Huang, M. (2012). The Review of Asset Pricing Studies, 2(2), 153-202. According to this paper, it has been observed that credit risk only involves little of yield spread as regards the investment-grade bonds. The fraction is smaller with a bond of shorter maturities and a higher yield spread for a higher yield bond. This result was gotten by measuring each of the models and making them tally with the equity risk premia and the historical default loss.
- · A re-examination of the predictability of economic activity using the yield spread, Hamilton, J. D., & Kim, D. H. (2000). (No. w7954). National Bureau of Economic Research. This paper explains the importance of yield spread in predicting the real GDP growth of an economy in the nearest future. It explains that the usefulness of the spread can be divided into the effect of the hypothesized future changes in the short rates as well as the effect of premium. In other to accurately predict the growth of the real GDP, these factors must be considered, although, they differ in their contribution. According to this paper, while volatility sows important similarities between GDP and the structure of interest rate, it does not really account for the usefulness of the yield spread in predicting the future real GDP.
- · Predicting real growth and inflation with the yield spread, Kozicki, S. (1997). Economic Review-Federal Reserve Bank of Kansas City, 82, 39-58. Although, financial variables according to several analyses have helped to predict the real activity and inflation rates. But, one of the most important methods is the use of the spread between yield both on the long and short run. This yield is also known as the yield spread. Hence, in other to achieve an effective evaluation of the real activity, you might want to consider employing the use of the yield spread. According to Economist scholars, (Bonser-Neal and Morley), they ascertain that the yield spread is an important tool in predicting an economy future real activity. While Kozichi furthers her research on the basis of the former economist, she concluded that the predictive power of the yield spread is as a result of the real growth and inflation of the industrialized countries.
- · Does the Yield Spread Predict Recessions in the Euro Area?*, Moneta, F. (2005). International Finance, 8(2), 263-301. This research analysis explains the content of the slope of the yield curve as an important tool in predicting the recession in the euro area and provide an alternative use for monetary policymaking. A probit model was constructed which helps to determine the historical predictive power of over ten variations of the yield spread in a yield curve. The yield spread obtained from the ten-years and three-month interest rate appears to contain information that is more than the available ones in the history of the output level of an economy and can also override other competitor’s indicator.
- · Unconventional monetary policy and the great recession-Estimating the impact of a compression in the yield spread at the zero lower bound, Baumeister, C., & Benati, L. (2010). This research paper adopted the use of a structural VAR model to study the macroeconomic effect of the yield spread on long-term bond within the scope of the Great Recession of 2007-2009. The pure spread shock is defined as the shock that leaves the polity rare unaltered was developed. This pure spread shock helped us to categorize the macroeconomics consequence under the environment in which the policy rate is limited by an effective zero lower bonds. Two key features were developed according to this paper; compression in the long-term yield spread possesses a powerful effect on inflation and output growth. Second, counterfactual simulations suggest that the U.K and U.S monetary action have prevented the risk of deflation and collapse of output.
- · Kickbacks or compensation: The case of yield spread premiums, Jackson, H. E., & Burlingame, L. (2006). Stan. JL Bus. & Fin., 12, 289. This paper explains whether the yield spread premium is dangerous to consumers and how it could be regulated. Note that the yield spread premium is the payment made to most mortgage brokers. After the regulatory framework of the yield spread premium has been defined, the unresolved empirical study shows that the yield spread premium allows mortgage brokers to exploit customers by demanding for high payments for transactions. According to estimates, the consumer gets less than the 35 cents of the value of the yield spread medium. According to this paper, the yield spread medium might assist mortgage brokers in becoming a monopoly.
- · Testing for asymmetry in the link between the yield spread and output in the G-7 countries, Galbraith, J. W., & Tkacz, G. (2000). Journal of International Money and Finance, 19(5), 657-672. The direction of monetary policy has been evaluated through the process of using business cycle leading indicator and as an indicator of the direction in yields between the long term and short term securities. This research observes the irregularities in the form of a threshold effect in such a way that the impact of the yield spread on the growth of output is greater on one of the thresholds than the other side. According to this paper, data gotten from G-7 countries were used and the result indicates that the yield spread does not show a significant relationship with the output in both Canada and the United States.
- · Determinants of yield spread dynamics: Euro versus US dollar corporate bonds, Van Landschoot, A. (2008). Journal of Banking & Finance, 32(12), 2597-2605. This research work base its assumption mainly on the methodical comparison between the determinants of US dollars and euro yield spread dynamics. According to the result of this research, the US dollar yield spreads are very much affected by the changes in the slope and level of the structure and the stock market volatility and returns. The euro yield spread is directly influenced by the US slope and level. Hence, the dormancy of the US interest rate is the corporate bond market. The credit cycle also increases the US yield spread and decreases that of the euro.
- · Explaining the yield spread between taxable and tax-exempt bonds: The role of expected tax policy, Poterba, J. M. (1986). University of Chicago Press. This paper explains the role of yield spread in the relationship between the taxable and tax-exempt bond and it also explains the various roles of the expected tax policy of an economy.
- · Predicting real growth and the probability of recession in the Euro area using the yield spread, Duarte, A., Venetis, I. A., & Paya, I. (2005). International Journal of Forecasting, 21(2), 261-277. According to this paper, the research analyses propounded by past economists indicates that the economic activities in the US and EU defines the relationship between the term spread-output growth as unstable and may as well be subjected to nonlinearities. According to the data obtained for the Euro area from 1970:1-2000:4, a linear and nonlinear regression model was applied to observe the accuracy in the predictive power of the term spread-output growth relationship. The result confirms the yield curve as a leading indicator. Also, in other to successfully predict EMU recession, a probit model that uses US and EMU yield spread were adopted.
- · The high-yield spread as a predictor of real economic activity: evidence of a financial accelerator for the United States, Mody, A., & Taylor, M. P. (2003). IMF Staff papers, 50(3), 373-402. This paper explains the high yield spread as an important factor in predicting real economic activities using the evidence of the financial accelerator for the United States as a case study.