What Is a High-Yield Bond Spread?
Let me explain what a high-yield bond spread is: it's the percentage difference in current yields between various classes of high-yield bonds and benchmarks like investment-grade corporate bonds, Treasury bonds, or another standard measure. You often see these spreads expressed in percentage points or basis points, and they're also commonly called credit spreads.
Key Takeaways on High-Yield Bond Spreads
As I see it, a high-yield bond spread, or credit spread, is simply the yield difference between high-yield bonds and a benchmark such as investment-grade or Treasury bonds. These high-yield bonds provide higher yields because of their default risk—the greater that risk, the higher the interest they pay. You can use these spreads to evaluate credit markets, where an increase in spreads might point to weakening macroeconomic conditions.
How a High-Yield Bond Spread Works
A high-yield bond, which you might know as a junk bond, offers a high interest rate due to its elevated risk of default. These bonds carry lower credit ratings than government or investment-grade corporate bonds, but that higher yield attracts investors. The high-yield sector doesn't correlate much with other fixed income areas and isn't as sensitive to interest rates, so it works well for diversifying your portfolio.
The bigger the default risk on a junk bond, the higher its interest rate. One way you assess that risk is through the high-yield bond spread, which is the yield difference between low-grade bonds and stable high-grade or government bonds of similar maturity.
When the spread widens, it means the perceived risk of junk bonds is rising, which could lead to higher returns for those willing to invest. This spread acts as a risk premium—you take on more risk for the chance of higher earnings.
Typically, you evaluate high-yield bonds against U.S. Treasury bond yields. A company in weak financial shape will show a high spread relative to Treasuries, unlike a strong company with a low spread. For instance, if Treasuries yield 2.5% and low-grade bonds yield 6.5%, the credit spread is 4%, or 400 basis points.
Remember, spreads wider than historical averages suggest greater credit and default risk for junk bonds.
Benefits of High-Yield Bond Spreads
Investors and market analysts like you use high-yield spreads to gauge the overall credit markets. Changes in a company's perceived credit risk create credit spread risk. For example, if lower oil prices hurt many companies, expect the high-yield spread to widen, with yields up and prices down.
If market risk tolerance is low and people shift to stable investments, the spread increases. Higher spreads point to elevated default risk in junk bonds and can reflect broader issues in the corporate economy, credit quality, or macroeconomic weakening.
These spreads are most valuable when viewed historically—you want to compare today's spread to past averages. If it's too narrow now, smart investors might skip junk bonds. But if the spread is wider than average, high-yield investments become more appealing.
