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.
Table of Contents
- Building an Investment Yield
- What Are Yield Spreads?
- 5 Yield Spread Factors
- One Additional Yield Spread Factor – The Market
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.
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.
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.