Using Spreads to Sharpen Portfolios
In a previous article, we explored how investors use spreads to monitor the yield differentials between bonds with varying characteristics such as maturity, credit rating, issuer, or country of domicile.
Bond spreads – and the changes in spreads over time – offer valuable insight into market sentiment, reflecting factors such as corporate fundamentals, credit conditions, and broader economic trends.
To make use of this information, investors evaluate several types of spreads.
Understanding the credit spread
The difference between the yield on a high-quality government bond and a non-government bond is called a credit spread. Credit spreads help investors gauge how much additional return they should expect for taking on extra credit risk. Because the comparison is made with the highest-quality government debt, a credit spread offers a baseline view of credit risk. Examples include:
- The five-year corporate bonds of a blue-chip company may yield only a few basis points more than a U.S. Treasury with the same maturity, reflecting investors’ belief that the company faces very low default risk.
- At times, highly rated corporate bonds have traded at negative spreads to U.S. Treasuries. This typically reflects strong demand for the corporate issuer’s debt, differences in liquidity, or unique market dynamics.
- The spread between the debt of a relatively young or lower-rated company and Treasuries is typically be much wider, because investors require greater compensation for lending to a less established or riskier business. If that spread narrows over time, it may indicate improving market confidence in the company’s prospects.
Investors also monitor the spread between government bond yields and an aggregate of similarly rated corporate bonds (for example, all AAA rated 5-year corporate bonds within a particular country or industry sector). They then compare those spreads with historical averages to assess market sentiment and risk appetite.
- Widening spreads signal that corporate bonds are becoming cheaper relative to government bonds, often occurring during periods of heightened risk aversion.
- Narrowing spreads suggest that corporate bonds are becoming more expensive, with lower yields, which may indicate that it is not an ideal time to increase portfolio allocations to corporate debt.
Credit spreads are a key measure of investment risk
Assessing yield spreads
A yield spread represents the difference between the yields of two bonds, helping investors assess the relative value and risk of one bond (or group of bonds) versus another part of the market.
For example, an investor considering increasing their allocation to short-term high-yield corporate debt might:
- Begin by examining the credit spread between an index of 1-year high-yield bonds and a government bond of the same maturity, and then compare that spread with historical averages to gauge current market sentiment.
- Analyse the yield curve. A steepening yield curve often signals improving investor confidence and stronger growth expectations, while a flattening or inverted yield curve may indicate rising caution.
- Compare regional yield spreads, such as the spread between U.S. and European high yield corporate debt, to understand differences in valuation and perceived risk across markets. This may reveal, for instance, that investors currently view European high yield debt more favourably due to relative fundamentals, liquidity conditions, or economic outlook.
Why spreads are important
Spreads can vary widely between bonds of different credit ratings, geographic regions, market types, and industry sectors. Analysing spreads is therefore a valuable tool for understanding the relative risks and potential returns of trading a particular bond at any point in time.
For instance, an unusually narrow spread may indicate that a specific bond or group of bonds is relatively expensive compared with its historical average, potentially signalling a selling opportunity. Conversely, a wider‑than‑normal spread may indicate relatively attractive valuations or highlight areas where higher yields may compensate for higher perceived risk.
Understanding how to interpret spreads helps investors assess the market’s view of overall economic and corporate health. It also enables them to add diversification to a fixed income portfolio by combining assets with varied risk and return profiles.
