Yield Spread: The Building Blocks of Yield

Yield Spread: The Building Blocks of Yield

As you evaluate investments for the portfolio, you’ll no doubt see differences between the yields on different securities.  The primary factor that affects the yield is called the yield spread.  What is the yield spread, and what influences it?

To understand all the moving parts, let’s go through the process of building an investment yield.  We’ll find that the yield on every fixed-income security is made up of a series of components.  These will differ to some degree from bond to bond.  They’re like Lego blocks in that each yield comprises these pieces that, once connected, make up the yield spread for that fixed-income investment.

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Building an Investment Yield

As we begin the process of building an investment yield, let’s start with the foundation of all yields – the risk-free rate.

The risk-free rate comes from the U. S. Treasury market.  Because Treasuries carry what’s known as the “full faith and credit” backing of the U. S. Federal government, they are considered a risk-free investment.  The Treasury rate for a given term to maturity is the base rate for all fixed-income securities. 

Unlike risk-free Treasuries, other bonds contain one or more embedded risks.  Because they have some form of risk exposure, the corresponding rates should be higher than Treasuries. 

It’s the whole risk/reward equation.  If the investor is not compensated for the risks they’re taking, they might as well go ahead and just buy the risk-free Treasury, right? 

The more risks that an investment has, the higher the reward.  We call this difference in yield between risk-free and risky fixed-income investments the yield spread.

(Note:  Of course, tax-exempt municipal bonds typically carry lower rates than Treasuries with the same maturity.  That’s because their interest is not subject to Federal income taxes and, in some states, exempt from state income taxes as well.)

What Are Yield Spreads?

When evaluating a bond or other fixed-income investment, you should find that it is trading at a higher yield than the comparable risk-free Treasury rate.  The yield spread, or the difference between the Treasury rate and the other investment, is quoted in basis points. 

Graphic explanation of yield spread

For example, when a broker shows you a bond for consideration, they may say that it is trading at a “+25 spread to Treasuries” or “+25 to the curve.” This means the yield spread is 25 basis points above the comparable Treasury rate.  If the Treasury rate is 1.50%, and an investment is trading at a +25 spread, then the yield on the investment is 1.75% or 25 basis points above the Treasury rate.

5 Yield Spread Factors

What determines the amount of the yield spread on a fixed-income security?  There are five fundamental risk factors that can contribute to the yield spread.  The first two are considered part of all fixed-income yields (including Treasuries), while the others are specific to non-Treasury investments.

Factor #1: Maturity Premium

Also known as the term premium, the maturity premium is the extra return an investor requires as compensation for tying up their money for a given period.  The longer the period, the higher the premium. 

The maturity premium helps establish the positive slope in a normal yield curve, with longer-term yields at higher levels than shorter yields.  Because there’s a higher potential risk of things going wrong over the long term, which might prevent payment of principal and interest as expected, the yield spread is higher to reflect that risk.

Factor #2: Inflation Risk Premium

The inflation risk premium is the portion of a bond’s yield an investor desires based on their expectations for future inflation between now and when the investment matures.  An investor wants to be compensated for the loss of purchasing power of their investment.  If investors anticipate the potential for rising inflation, they’ll be looking for a higher inflation premium.  This is especially true if an investor is also considering a longer investment.  In that case, both the maturity and inflation premiums can become inter-connected, as investors want to be sure that they will not come up short because of inflation risk over time.

The fundamental factors of yield and yield spread
The Building Blocks of Yield and Yield Spread

Factor #3: Credit Risk Premium

A security’s credit risk refers to the possibility that a bond or fixed-income security issuer is unable to make principal and interest payments on time.  We’re basically talking about a default on the investment. 

If the issuer of a fixed-income security has a higher potential likelihood of going belly-up, the yield spread on investments issued by them should be higher.  That’s why Treasuries are considered risk-free and form the base rate, as mentioned previously.  And it’s why fixed-income investments with lower credit ratings carry a higher yield spread.

Factor #4: Liquidity Risk Premium

Liquidity risk is the inability to liquidate or convert a security to cash.  A security may carry a liquidity risk premium if it cannot be easily sold or converted into cash at its fair value.  The more difficult it is to liquidate a security at its fair value, the higher the liquidity premium it will have and the greater the yield spread. 

Investment liquidity risk is less of a factor for community bankers, as most of the investments held by financial institutions in the investment portfolio are generally pretty liquid.  But there are examples of illiquid investments, including trust preferred securities, bank sub-debt, and private placement investments.  Such investments would carry a higher liquidity premium and higher yield spread.

Factor #5: Option Risk

Option risk, also known as optionality, refers to an investor’s extra compensation for investing in a security containing some form of embedded call options.  An investor will receive a premium for that option in the form of a higher yield.  That’s why callable bonds have higher yields than non-callable bullet bonds.

Those are the five risk factors that go into a yield spread.  What’s important to keep in mind is that if you are considering an investment with any of these five risks, you should receive some level of yield spread above the risk-free Treasury rate.  Again, you’re better off buying the comparable Treasury if you’re not.

One Additional Yield Spread Factor – The Market

Another factor that can affect the yield spread on a fixed-income investment that isn’t risk-related is the market itself.  Simply put, the yield spread on a fixed-income security can change as the demand for that type of security changes. 

For example, as the demand increases for a fixed-income investment, it drives its price higher.  And since the relationship between price and yield on fixed-income securities is inverse, a higher price equals a lower yield. 

If an investment’s yield decreases faster than the comparable Treasury yield, the yield spread will narrow.  Under those circumstances, higher demand and bond prices can lead to lower overall yields, and reduced yield spreads.

This has been a challenge we’ve been facing over the past year as investors search for places to put funds to work.  And for financial institutions that have experienced an influx of cash and tepid loan demand, it’s only increased the demand for investments.  Because of this, we’ve seen spreads on fixed-income investments get smaller and smaller. 

In some cases, the yield spread for a security could end up being just a few basis points above Treasuries.  In those instances, you have to question whether it’s worth the few basis points in yield versus buying the Treasury.  The answer to that question will vary depending on an investor’s situation.

The reverse is true when demand weakens.  When that happens, a fixed-income investment’s price can decline, leading to a higher yield.  If that yield increases more quickly than the Treasury rate, the yield spread will widen.

When evaluating investments, looking at yield spreads as part of your analysis is a good idea.  Check the investment’s yield spread versus the comparable Treasury maturity.  As you do so, remember to think about what risk factors are in play for each investment so that you can make a proper comparison.

What Is a Yield Curve and What Does Its Slope Mean?

What Is a Yield Curve and What Does Its Slope Mean?

For investors in fixed-income securities, yield and interest rates are critical drivers when making investment decisions.  If you follow the bond markets, you’ll no doubt hear mention of the yield curve and its slope.  But what are they, and can they provide insight into future interest rates and the overall economy?  Let’s explore what the yield curve is and how to interpret the shape of the curve.

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What Is the Yield Curve?

The yield curve graphically depicts the yields on different maturities of debt instruments.  It is simply a line plot of interest rates by maturity, providing investors with a visualization of yields and interest rates.  If you take all the yields for a given type of interest rate (for example, Treasury rates) and plot them on a line, congratulations!  You’ve got a yield curve.

A yield curve plots the yields of different maturity bonds against their corresponding time to maturity, allowing investors to visualize the term premium (or discount) for each maturity.  Typically, long-term yields are higher than short-term ones since investors want to be compensated for tying their money up for more extended periods, known as “maturity risk.”  Investors also consider potential inflation and any loss of purchasing power over time.

You can plot a yield curve for any fixed-income bond type.  For example, you can find curves for Treasury and other government bonds worldwide, municipal bonds, agency bonds, and corporate bonds.  If you have access to Bloomberg (either directly or with the help of a broker), you’ll find dozens of curves available.

What Is the Yield Curve Slope?

When we’re talking about yield curves, there’s one term with which you need to be familiar.  That is the term “slope.” The slope is the difference between short-term and long-term interest rates on the curve.  A common slope measure is the difference between two-year and ten-year Treasury yields, otherwise known as the “2s/10s spread.”

Usually, a yield curve will have higher rates as you move further out the maturity scale.  This goes back to the idea of maturity risk that we discussed earlier.  We refer to this as a positively sloped yield curve, with longer rates higher than shorter ones.

Chart showing the yield curve's slope

There are three basic yield curve shapes that you’ll want to know.  Each of them depends on the degree of slope in the curve.

Steep Yield Curve

A steep curve happens when you have a yield curve with very high long-term rates compared to short-term rates.  As you look at the curve, it looks like a very steep hill that rolls down sharply as you move from long- to short-term rates. 

Chart showing an example of a yield curve with a steep slope
Example of a Steep Curve Slope (Source: Bloomberg)

We usually see a steep curve when the market outlook is for stronger economic growth or rising inflation.  Investors interpret the higher long-term rates as a sign that the market expects the Federal Reserve to raise interest rates in the future.

Flat Yield Curve

A flat curve occurs when the slope of the yield curve is very narrow, meaning there’s little difference between short- and long-term interest rates.  When the yield curve is flat, it may signal that the market expects interest rates to stay relatively stable in the near future.  

Chart showing example of yield curve with flat slope
Example of a Flat Curve Slope (Source: Bloomberg)

A flat curve can also indicate that the market is anticipating a period of economic stagnation.  The curve generally becomes flat later in the economic cycle as investors expect an economic slowdown or if the inflation outlook is decreasing.

Inverted Yield Curve

An inverted curve is when short-term interest rates are actually higher than long-term ones.  It’s a rare occurrence, and it sounds strange since a normal yield curve has higher long rates and a positive slope. 

Chart showing example of yield curve with inverted slope
Example of an Inverted Curve Slope (Source: Bloomberg)

Historically, an inverted curve often occurs before a recession and usually after a period of increased interest rates by the Fed.  An inverted curve isn’t a guarantee that a recession is imminent, but it is the market beginning to price in an economic slowdown.

What Drives the Slope?

The yield curve’s slope is constantly changing, ebbing and flowing, and becoming steeper or flatter.  So, what determines the shape or slope of the curve?  Three primary factors can cause the curve to steepen, flatten, or even become inverted. 

Monetary Policy

One factor is the Federal Reserve’s monetary policy decisions.  As the Fed raises or lowers interest rates, and the bond market anticipates and reacts to those moves, it will influence changes in the yield curve.   The Fed’s rate decisions primarily affect the shorter end of the curve, usually out to about two or three years.

Inflation Expectations

Another factor that influences the curve slope is inflation expectations.  As I mentioned earlier, fixed-income investors will factor in the loss of purchasing power and want to be compensated for that risk.  If the market anticipates a higher probability of inflation, then interest rates and the yield curve will adjust to reflect that scenario.  And if inflationary concerns are diminished, that will also be taken into account.

Market Supply and Demand

The third factor that can affect the slope is the combination of bond market supply and demand.  As bond issuance of different maturities changes over time, and as demand for those bonds fluctuates, it affects the price of the bonds, which in turn drives the rate or yield.  As those conditions change, the rates represented on the yield curve will move accordingly, changing the slope of the curve in the process.

What Part of the Curve Matters?

As you might expect, yield curves and slopes get a lot of attention in the bond markets, mainly the Treasury curve.  Because of that, it can be easy to get caught up in the latest financial headlines about the 10-year Treasury or other yield indices along the curve. 

But here’s something to keep in mind.  As you evaluate the curve and its slope, ask yourself – What part of the yield curve matters most to your financial institution? 

If most of your institution’s earning assets are no longer than five years in terms of maturity or repricing, then why worry about what the 10-year Treasury is doing?  The key is to focus on the part of the curve where your assets (including investments) and liabilities reside and base your asset-liability strategies and investment decision-making on your financial institution’s unique yield curve.

The yield curve is an essential tool for financial institutions to use to make decisions about their investment and balance sheet strategies.  By understanding the factors that drive the curve and its slope, investors can better position themselves as market and economic conditions shift.

While no one can predict the future with certainty, by paying attention to how short- and long-term interest rates are changing, community financial institutions can do their best to stay ahead of the curve.

Great Podcast Series on the LIBOR Transition

Great Podcast Series on the LIBOR Transition

Bloomberg’s “Odd Lots” podcast, co-hosted by Joe Weisenthal and Tracy Alloway, recently produced a five-part series on LIBOR. It covered the retirement of the benchmark index, a long-time cornerstone in the capital markets. The series provided some great background and perspective.

To make it easier for you, here’s a list with links to each of the episodes in the series:

1 – Meet the Man Who Blew the Whistle on LIBOR: Features an interview with Richard Robb, who first raised concerns about LIBOR back in the mid-1990s.

2 – This is the Index That’s Supposed to Replace LIBOR: Discussion on the Secured Overnight Funding Rate (SOFR) with Joe Abate from Barclays.

3 – The Case for AMERIBOR as the Replacement for LIBOR: An interview with Richard Sandor from the American Financial Exchange about an alternative index to LIBOR.

4 – How the Transition from LIBOR is Actually Going: Features a discussion with Tom Wipf from Morgan Stanley about the transition process that’s underway.

5 – What Happened to LIBOR During the COVID Crisis: An interview with Josh Younger from JPMorgan, reviewing how LIBOR has behaved during the COVID crisis.

The podcast series is full of interesting history, context, and info, so check it out!

3 Reasons Why Your Bond Yield is Misleading

3 Reasons Why Your Bond Yield is Misleading

Early in my career, I learned that the most important consideration for bond investments was a bond’s yield. After all, if we don’t know the potential return on a bond, how do we select the investment that might be best for our needs?

In fact, when speaking with brokers or reviewing Bloomberg screens, most of what you will see is based on the bond’s yield. However, there are three important factors about the bond yield calculation that may make it a misleading measurement.

Exactly What Does “Yield” Mean?

Most of the time, when we talk about yield, we’re referring to the yield-to-maturity (YTM). YTM is the annual return that an investor can expect to earn on a bond investment over its lifetime. It takes into account the interest income earned, the principal cash flow when the bond matures, and any premium or discount paid. For those that are more statistically-minded, YTM represents the internal rate of return (IRR) necessary to discount all future cash flows so that the sum of their present values is equal to the bond’s current price.

YTM provides a summary measurement of all the bond’s cash flows, including principal received at maturity. Many investors believe that YTM offers a clear indication of the return they will earn. However, to truly realize a bond’s YTM, several key assumptions need to be met:

  1. The bond is held to its final maturity.
  2. All income is reinvested at the same rate as the YTM.
  3. You receive all interest and principal payments on schedule.

Because of these assumptions, you’ll face three reasons why you might not earn the YTM on a bond investment:

Reason #1: You Don’t Hold the Bond Until It Matures

While your intent may be to hold your bonds until final maturity, that may not always be the case. Bonds can be sold before maturity for several reasons. These can include liquidity needs, changing risk factors, or adjustments to the portfolio investment mix. Depending on the original price paid, if you sell a bond before it matures, you may realize a gain or loss on the sale, and your return will vary from the YTM.

Reason #2: You Don’t Reinvest the Income You Earn

As mentioned above, one of the assumptions is that any income received is reinvested at the YTM interest rate. While this is difficult to do (though not impossible if you invest in zero-coupon bonds), the reality is that your return will vary from the expected YTM as coupon income is reinvested at rates that vary from the original YTM (if it is reinvested at all).

Reason #3: Optionality Changes the Payment Schedule

Since YTM assumes that you receive all payments as scheduled, it also assumes the absence of any embedded options. Once optionality is introduced, as in the case of callable bonds or securities with prepayment risk like mortgage-backed securities, it has a direct influence on the actual yield. It also results in a difference when compared to the YTM.

Some metrics, such as yield-to-call (YTC), help to quantify some of the effects of optionality. However, what about when the bond contains multiple embedded calls? How do you know what your yield will be then? Below is a snapshot from a Bloomberg screen for a callable step-up agency bond. As you can see, your yield can vary depending on whether (or when) the bond is called.

Which Bond Yield?

It is more challenging to determine the possible yield on a security with prepayment risk, such as an MBS. As the Bloomberg screenshot below shows, the yield to maturity can change throughout the investment’s life as principal payments vary due to optionality.

Which Mortgage Bond Yield?

The bottom line is that basing an investment decision solely on the yield at the time of the purchase isn’t necessarily telling you the whole story.

Is Using Yield a Worthless Exercise?

So with all the reasons that the YTM calculation doesn’t provide an entirely accurate result, does that mean it is a useless measurement or a waste of time? No, not really.

While it may not be a perfect metric, YTM allows you to make a direct comparison between different securities, taking into account different coupons and prices. It combines all the different cash flows into a single statistic and allows a quick apples-to-apples comparison of the potential return you could earn on your investment based on “what might be.”

However, it is probably best not to use YTM as your sole measurement for evaluating fixed income securities. It is better to blend YTM with other factors such as duration, weighted average life, and total return when analyzing bonds. These measurements, along with your specific balance sheet needs and risk tolerances, will help shape the overall picture required to make a sound investment decision.