The difference in yields between multiple high-yield bonds
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A high-yield bond spread, also known as a credit spread, is the difference in yields between multiple high-yield bonds, expressed in basis points or percentage points. A high-yield bond is a term that also refers to a junk bond.
For example, if bond A and bond B offer a yield of 7% and 10%, respectively, the spread of the yields between the two bonds is 3% or 300 basis points. Also, the yields on bonds are always moving, so they are not fixed, meaning that the spread on bond yields is constantly moving.
Junk Bonds vs. Government Bonds
High-yield bonds, or junk bonds, are often compared to bonds issued by the government. The bonds are issued by organizations with weak credit ratings. As a result, there is a high level of default risk, which means the bonds offer a higher interest rate because investors need to be compensated for taking on the risk profile. Therefore, junk bonds are often referred to as high-yield bonds because there is a risk premium.
On the other hand, government bonds are safer. They also come with stronger credit ratings and a lower chance of default risk. As a result, government bonds do not provide as high a yield compared to junk bonds.
Although junk bonds generally come with worse credit ratings than government bonds, the high interest rate is why some investors choose to invest in junk bonds. In such a case, the high-yield bond spread is the difference between the yield on government bonds versus the yield on junk bonds.
If the spread between junk bonds and government bonds increases, it indicates an even larger difference between the yields of both bonds. It further indicates that there is an even bigger risk of investing in the junk bond in comparison to the government bond.
Importance of a High-Yield Bond Spread
A high-yield bond spread shows an inverse relationship between bond yields and bond price, which can tell you if one sector is performing better than another sector. If bond prices increase, there will be a decrease in bond yields. On the other hand, if bond prices decrease, there will be an increase in bond yields. It is useful to know because an increase in bond yields is an indication that one sector is performing better than other sectors.
For example, suppose the yield between junk bonds in one particular sector moves from 5% to 5.5%. In contrast, the yield on a government bond stays constant at 3%. The spread between the junk bonds and the government bond moves from 2% to 2.5%, which indicates that the yield on the junk bonds underperformed the government bond. By understanding which sector performed better, investors can take advantage of yield spreads.
Advantages of a High-Yield Bond Spread
High-yield bond spreads are beneficial to investors because they can be used to assess the credit markets and evaluate the state of the economy. For example, if the spread between two bonds becomes larger, it implies that there is a higher default risk in junk bonds. Therefore, it indicates a weakening of the macroeconomic environment and the worsening of the credit quality offered by the junk bonds.
Additionally, high-yield bond spreads can be used by investors to understand how much additional yield they can get if they invest in a particular bond instead of another bond. For example, an investor can compare the difference in yields between two junk bonds. Calculating the yield spread between the two bonds can indicate how much more additional risk investors are taking on if they invest in one junk bond rather than the other.
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