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 measures 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, indicating stable economic conditions in the future. Contracting, or falling spreads, may indicate worsening economic conditions in the future, resulting in a flattening of the yield curve.
Yield spreads in the past year
The graph above shows the spread between the 2-Year and 10-Year US Treasury notes. The yield spread, which had been at 175 basis points at the beginning of 2015, fell to 121 basis points by the end of the year. Since then, spreads between these two notes have fallen for the most part. They’ve ranged between 98 and 123 basis points in 2016 so far. On February 25, 2016, the spread stood at 99 basis points. This is the lowest since December 28, 2007.
These numbers show that the yield curve has flattened. This has been the result of the yield on the 2-Year note surging in light of the rate hike, thus suppressing spreads.
Generally speaking, professional money managers shift to shorter maturity bonds in a rising interest rate environment, as these are the least sensitive to rises in interest rates. However, since inflation has remained suppressed, yields on longer maturity bonds (DRGBX) haven’t risen, unlike 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.
We’ll return to spreads later in the series. Let’s take a look at another important aspect related to yields: the term premium.
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