Yield Spread is the difference in the yield of any bond (PSU, corporate or banks) and Government bonds having the same maturity.
Government bonds are free from credit risk i.e. risk arising from the issuer of the bond defaulting in making the payment of the principal amount and interest.
Government bonds being default free, Gsec yields are taken as a benchmark against which other bond yields are compared. This enables the investors to get an idea of the credit risk associated in investing in bonds other than government bonds.
Investors to be compensated for investing in less safer bonds than the government bonds demand higher yield than Gsec resulting in the differences in the bond yields.
Yield Spread is the difference in the yield between two bonds of the same maturity.Commonly, the yield spread is the difference in the yield of any bond (PSU, corporate or banks) and Government bonds having the same maturity.
Suppose AAA 10-year corporate bond yield is 8.6 percent and 10-year Gsec yield is 7.46 percent then, the yield spread is 114 bps (1.14 percent).
Spread is generally expressed in basis point (bps) where 1 percent is equal to 100bps.Risk
Yield spread reflects the extra compensation investors receive for bearing credit risk.
Higher the credit risk, higher is the yield spread, as investors need to be paid in order to take the additional risk.
What causes changes in Yield Spread
Yield spread can increase i.e. widen, or decrease i.e. narrow. Widening yield spread means yield difference between other types of bonds and government bonds is increasing while narrowing yield spread means the difference is decreasing.
Changes in the yield spread are due to changes in the interest rates, supply and demand of bonds, the risk associated with the bond and economic conditions.
Any change in interest rates causes the yield on government bonds to change. Since other types of bonds are benchmarked against Gsec yield, any change in Gsec yield may cause other bond yields to change.
When there is an economic slowdown, company performances are impacted which increase their credit risk. This causes yields on corporate bonds (or PSU, bank bonds) to increase, to compensate investors for the additional risk involved, thereby widening yield spread.
Also during deteriorating economic environment with credit risk of companies increasing, investors choose to invest in safer bonds i.e. government bonds rather than riskier corporate bonds. This leads to a fall in Gsec yields as demand increases causing the bond price to rise and yields to fall. As yields on corporate bonds are rising and Gsec yields are falling, resulting yield spreads to widen.
Conversely, when the economy is booming, company profitability increases improving their performance lowering their credit risk. This causes investors to view investments in corporate bonds as favorable, causing yields to fall, thereby narrowing yield spread.
Also during a booming economy with lower credit risk, investors invest in corporate bonds rather than government bonds. Since the demand for government bond falls, it causes their yields to rise.Given below is the chart for AAA Corporate Bond yields and Gsec 3 years Benchmark. The spread had widened between them during December 2008, while it is narrowing for the current period.
AAA Corporate Bond 3 yrs & Gsec 3 yrs Index
The above chart shows the yield spreads over the last 10 years. We can observe that higher the credit risk, higher is the bond yield.
Corporate AAA bond having highest credit rating has lowest spread. As we can observe from the above chart. The spreads between the AAA corporate bond and AA corporate bond had narrowed during June 2014.
Corporate AA bond having a lower credit rating, which means higher credit risk, has a higher spread. As seen in the chart, the spreads between AAA corporate bond and A corporate bond narrowed during December 2014.
Corporate A corporate bond has the lowest rating and highest risk among the three bonds. The spread between the AAA corporate bond and A corporate bond were high in Jun 2016.
Given above is the chart of yield spreads for various corporate bonds over the last 10 years, as compared to Gsec 3 years in basis point. The minimum spreads during 2008-2018 was between AAA corporate bond and Gsec 3 years index, of 56bps. While the maximum spreads for A Corporate bonds were 502bps.
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