The term bond spreads, or spreads, describes the interest rate differential between two bonds. Mathematically, it’s determined by subtracting the lower interest rate from the higher one.
Spreads are quoted in “basis points”, with a 1% spread more commonly referred to as 100 basis points.
Bond spreads are how market participants compare the value of one bond to another, similar to how price-earnings or P/E ratios are used to compare stocks. The spread tells an investor how relatively cheap or expensive a bond is.
When referring to bond spreads, people are generally trying to compare the yields on federal government bonds — the most creditworthy bonds of them all — to those on bonds from other issuers, like provinces, states, municipalities or corporations.
The other entities are higher-risk borrowers than most federal governments since there is a greater risk of non-payment or default. Bond spreads reflect the relative risks of the bonds being compared. The higher the spread, the higher the level of risk, typically.
Market interest rates are dynamic and so too are bond yields. As a result, yield spreads cannot be static — they too are always in motion. Changes in the spread indicate that general market conditions have changed and/or perceptions about the risk of a specific issue or issuer have changed.
A yield spread can increase or widen, which means that the yield differential between those two bonds is increasing. Spreads can also narrow or tighten, which means the yield differential is decreasing.
Credit spreads are an indication of investor confidence. If investors become more concerned about the creditworthiness of an issuer, the spreads on those bonds would widen (the yield relative to the benchmark will have increased). Or, if market sentiment becomes more negative and inventors more risk-averse, spreads will generally tend to widen. Conversely, if sentiment around market conditions or an issuer improves, then spreads would decrease. Bond spreads can also be calculated between bonds with different maturities, coupon interest rates or even different countries and currencies.
Understanding how spreads work, will help you understand the value of one bond relative to another.