What are yield spreads?
Yield spreads refer to the difference between the yields of two fixed income securities. They can either be of the same or different credit quality. In this article, we’ll look at yield spreads between Treasury securities. Spreads are measures in bps (basis points). One basis points is a hundredth of a percentage point. So 1.0% = 100 basis points.
What do spreads indicate?
Yield spreads between different-maturity Treasury securities, when compared to the historical trend, can indicate how market participants are viewing economic conditions. Generally speaking, widening spreads lead to a positive yield curve, thus indicating favorable and even stable economic conditions in the future. When falling spreads contract, however, it may indicate worsening economic conditions in the future, thus resulting in a flattening of the yield curve.
How do spreads look currently?
In the above graph, you can see the spreads between two-year and ten-year Treasury securities as well as the five-year and 30-year Treasury securities. In the eight-year period shown on the graph, the yield spread between two-year and five-year securities fell to a low of 32 bps. The spreads between five-year and 30-year securities fell to 46 bps.
Both of these spreads occurred in August 2007. This was in line with worsening economic conditions that followed. By February 2011, yield spreads between these securities had risen to 291 bps and 284 bps, respectively. As of August 21, 2015, these yield spreads are down to 141 bps and 130 bps, respectively.
What’s the reason for the fall?
There’s debate whether the fall in August 2015 necessarily indicates worsening economic conditions ahead. One primary reason for the fall is mixed expectations by market participants. While a section of the market is readying itself for a rate hike perhaps as early as September, there are others who are focused on falling inflation. The former is leading to a rise in the short end of the yield curve (SHY), while the latter is leading to a fall in the long-term yield curve (TLT). This has helped decrease yield spreads.
Inflation expectations have been a key driver not only for Treasuries but also for investment-grade bonds and related ETFs such as the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD). LQD invests in bond issues of companies like Verizon (VZ), Apple (AAPL), and General Electric (GE).
In the next article, we’ll take a look at the measure of inflation expectations.