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. Spreads are measured in bps (basis points). One basis point is one-hundredth of a percentage point, so 1.0% = 100 basis points.

Yield spreads between different maturity Treasury securities, when compared to historical trends, can indicate how market participants view economic conditions. Broadly speaking, rising or widening spreads lead to a positive yield curve, thus indicating stable economic conditions. Contracting or falling spreads may indicate worsening economic conditions in the future, thus resulting in a flattening of the yield curve.

The State of Treasury Yield Spreads in 2015

Yield spreads in 2015

The graph above shows the spread between the 2-Year and 10-Year US Treasury notes. The yield spread, which stood at 175 basis points at the beginning of 2015, fell to 121 basis points by the end of the year. As of January 12, 2016, the spread stood at 119 basis points. For reference, the spread was at 266 basis points at the end of 2013.

These numbers show that the yield curve has flattened. This has been the result of the yield on the 2-Year note rising much faster than the yield on the 10-Year note, thus suppressing the spreads. Yields on short-term maturity securities are affected by changes in the federal funds rate, while yields on long-term maturity securities are affected by inflation expectations.

Generally speaking, in a rising interest rate environment, professional money managers shift to shorter maturity bonds. However, if inflation remains suppressed, longer maturity bonds (DRGBX) may fall less than shorter maturity bonds (PGVAX).

Investors should also be aware that theoretically, banks (JPM) (USB) (WFC) should benefit when rates rise. However, past rate hikes do not necessarily reflect this trend, and all banks do not benefit in equal measure.

In the next two articles, we’ll look at what professional money managers expect from the fixed-income market in 2016. We’ll look at PIMCO’s (Pacific Investment Management Company) views in the next article.

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