What it means
High-yield bonds, sometimes called junk bonds, are issued by companies with credit ratings below investment grade. Because these borrowers are more likely to fail to repay, investors ask for a higher interest rate.
The spread is simply the yield on these bonds minus the yield on a government bond with a similar life. The spread is a reading of fear and greed.
In calm, growing economies, investors accept a small extra yield, and the spread narrows. In a recession or a credit scare, they demand much more, and the spread widens, often before the economic damage shows up in official data.
Part of the spread pays for expected losses from defaults, and part pays for other risks, such as the difficulty of selling the bonds quickly and the chance of losses being worse than expected. A rough estimate of expected loss multiplies the default rate by the share of money lost on a default.
Whatever is left is the compensation for taking on uncertainty. Finance teams watch the spread for practical reasons.
It is a guide to the cost of borrowing for lower-rated companies, since new bonds are priced off it, and a sharp widening can shut the market altogether. Executives planning a refinancing or an acquisition often check the spread before choosing a date.
Several versions exist, including option-adjusted spreads that remove the value of features such as early repayment rights. Index providers publish daily series, and central banks and economists use them as indicators of financial conditions.
The numbers differ by index, so comparisons should use the same series over time. The spread also has a link to equity markets.
When high-yield spreads widen quickly, share prices often fall at the same time, because both reflect worry about company profits and funding. Risk managers therefore watch the two together when they stress test a portfolio.
In practice
Real-world examples.
Example
A chief financial officer of a leveraged retailer sees the spread jump from 350 to 700 basis points in a month. She postpones a planned bond issue, since the extra cost of about 3.5 percentage points on $200,000,000 would mean $7,000,000 more interest each year.
Example
A portfolio manager uses the spread as a signal. When it has narrowed to historically low levels, he trims high-yield holdings because there is little extra reward for the risk.
Example
An economist at a bank tracks the spread as part of a financial conditions index. A steady widening over several weeks leads her to lower her forecast for business investment.
Formula
Calculation
Spread = yield on high-yield bonds - yield on government bonds of similar maturity
Excess spread = spread - expected credit loss, where expected credit loss = default rate x loss given default
Suppose a high-yield index yields 8.5% and a government bond of similar maturity yields 4.0%.
Spread = 8.5% - 4.0% = 4.5%, which is 450 basis points.
Suppose the annual default rate is 4% and investors lose 60% of their money when a default happens.
Expected credit loss = 4% x 60% = 2.4%.
Excess spread = 4.5% - 2.4% = 2.1%, or 210 basis points. On a $1,000,000 bond portfolio, that is $21,000 a year of compensation for risks beyond expected defaults.Case study
Seen in the real world.
Kingfisher Packaging is a fictional company rated just below investment grade that needed to refinance $150,000,000 of debt. When its treasurer began planning, the market spread was 400 basis points over government bonds yielding 4%, implying a cost of about 8%.
Three weeks later, in this illustrative scenario, a wave of defaults in another sector pushed the spread to 650 basis points. The cost jumped to 10.5%, which would have added $3,750,000 a year in interest. The company moved quickly to use a bank loan instead and reviewed its refinancing calendar to avoid depending on a single date. It also agreed a revolving credit facility with its banks, so that a closed bond market would not leave it short of cash.
Watch out
Common mistakes.
- Treating the whole spread as profit, when a large part covers expected defaults and other risks.
- Comparing spreads from different indices as if they measured the same thing.
- Assuming a narrow spread means low risk, when it may mean investors are being paid too little for it.
Questions
People also ask.
What is a basis point?
It is one hundredth of a percentage point, so 450 basis points equals 4.5%.
Why does the spread widen in a downturn?
Investors expect more defaults and demand extra compensation, and some sell the bonds, which pushes yields up.
Is the spread a good recession indicator?
It is often a useful early warning, but it can give false signals and should be used alongside other data.
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