Legal Definitions - yield spread

A yield spread refers to the difference in the rate of return, or "yield," between two different investment securities. Investors analyze yield spreads to compare the relative value, risk, and other characteristics of various investments. A wider spread often indicates a greater perceived difference in risk, liquidity, or other factors between the securities being compared.

Here are some examples to illustrate how yield spreads are used:

• Comparing Government and Corporate Bonds: Imagine an investor is considering buying a U.S. Treasury bond, which is considered very low risk, and a bond issued by a large, stable corporation. If the Treasury bond offers a 2% annual yield and the corporate bond offers a 3.5% annual yield, the yield spread between them is 1.5% (3.5% - 2%). This spread compensates the investor for the slightly higher credit risk associated with lending money to a corporation compared to the U.S. government.
• Assessing Credit Risk Between Companies: Consider two different companies, Company A and Company B, both issuing bonds with similar maturities. Company A has an excellent credit rating, while Company B has a moderate credit rating due to higher debt levels. If Company A's bond yields 4% and Company B's bond yields 6%, the yield spread is 2% (6% - 4%). This 2% spread reflects the market's assessment that Company B's bond carries a higher risk of default, and investors demand a greater return for taking on that additional risk.
• Analyzing Bonds with Different Maturities: An investor might compare a 5-year bond issued by a municipality with a 20-year bond issued by the same municipality. If the 5-year bond yields 2.8% and the 20-year bond yields 4.2%, the yield spread is 1.4% (4.2% - 2.8%). This "term spread" typically reflects the additional compensation investors require for tying up their money for a longer period and for the increased exposure to potential interest rate changes over a longer horizon.