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[Economy] Yield Spread : Meaning and use Explained

What is Yield Spread?
Yield spread is a way of comparing any two financial products.
Yield spread is the difference between profit you can make in two different types of
investment.
Why do we need to calculate Yield spread?
Before coming to the purpose of calculating yield spread, lets go in a different
direction.
When you buy a Government bond, you can be certain that youll be paid in full, after
the maturity and theyll not run away. So in this case risk is very low, hence they sell
like hot-cakes. Thats why theyre called Gilt edged securities
When risk is low, it doesnt carry much profit.
But some junk company is issuing bonds, no one has ever heard of them.
So their bonds carry high-risk of default, hence people wont be interested in buying it as such.So,The company will offer extra-high
return (profit) on their bonds, to attract people.
In short : Higher return is offered when Risk is HIGH.
Scene 1: Year 2010
For every 100 rs. Invested in Government bond, you get Rs.5 return after 1 year.
For every 100 Rs. Invested in the junk bond, youre offered Rs.13 return after 1 year.
So yield spread = (13% minus 5%) = 8%
Scene 2: Year 2011
Government bonds return remains the same but now that junk bond company is offering you 20% return.
So Yield spread = (20% minus 5%)=15%
In one year, the yield spread has widened from 8% to 15%.
As we saw above, Higher the risk, higher return is offered.
So, 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 (due to an expanding
economy).
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rahul
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hi mrunal,
thanks for the beautiful article.
Generally such technical words come in the exam & we baffle .