1、Understanding Yield Spreadsby Frank J. Fabozzi,Copyright 2007 John Wiley less frequently used tools are changing bank reserve requirements and verbal persuasion to influence how bankers supply credit to businesses and consumers.,Interest Rate Determination,The actions of the Federal Reserve (Fed) in

2、fluence the level of interest rates as well as the state of the U.S. economy The Fed is the policy making body whose interest rate policy tools directly influence short-term interest rates and indirectly influence the long-term rates Once the Fed makes a policy decision it immediately announces the

3、policy in a statement issued at the close of the meeting The Fed also communicates its future intentions via the publishing of its meeting minutes, speeches, and testimony before Congress Bond managers pursuing an active portfolio management strategy closely watch the economy to anticipate a change

4、in Federal Reserve policy.,Interest Rate Determination,Bond managers closely follow: Non-farm payrolls Industrial production Housing starts Motor vehicle sales Durable goods orders National Association of Purchasing Management supplier deliveries Commodity prices Hurricanes, wars, and other internat

5、ional events,Interest Rate Determination,In implementing monetary policy, the Fed uses the following tools: Open market operations (most commonly used tool) Discount rate Bank reserve requirements Verbal persuasion to influence how bankers supply credit to business and customers,U.S. Treasury Rates,

6、U.S. Treasuries are generally considered to be “default risk free” The secondary market for Treasuries is an over-the-counter market where a group of U.S. government securities dealers maintain continuous bids and offers on outstanding issues The Treasury market is the most liquid financial market i

7、n the world,U.S. Treasuries,Because Treasury securities have no credit risk, market participants look at the interest rate or yield offered on an on-the-run Treasury security as the minimum interest rate required on a non-Treasury security with the same maturity. The Treasury yield curve shows the r

8、elationship between yield and maturity of on-the-run Treasury issues.,U.S. Treasuries,The Treasury issues the following securities: Treasury bills: Zero-coupon securities with a maturity at issuance of one year or less. The Treasury currently issues 1-month, 3-month, and 6-month bills. Treasury note

9、s: Coupon securities with maturity at issuance greater than 1 year but not greater than 10 years. The Treasury currently issues 2-year, 5-year, and 10-year notes. Treasury bonds: Coupon securities with maturity at issuance greater than 10 years. The Treasury currently issues bonds with maturities up

10、 to 30 years. Inflation-protection securities: Coupon securities whose principals reference rate is the Consumer Price Index.,U.S. Treasury Risks,Although Treasuries do not have credit, foreign exchange, or reinvestment risk (because they are non-callable), they are exposed to all of the other credi

11、t-related risks (i.e. interest rate, call, yield curve, liquidity, volatility, inflation, and event). The actions of the U.S. Federal Reserve and the other central banks can have an adverse or favorable impact on rates.,The Treasury Yield Curve,The yield offered on an on-the-run Treasury security is

12、 the minimum interest rate required on a non-Treasury security with the same maturity The relationship between the yield and the maturity of on-the-run Treasury securities is know as the Treasury yield curve,Treasury Yield Curve,The Treasury yield curve shows the relationship between yield and matur

13、ity of on-the-run Treasury issues. The typical shape for the Treasury yield curve is upward slopingyield increases with maturitywhich is referred to as a normal yield curve. Inverted yield curves (yield decreasing with maturity) and flat yield curves (yield roughly the same regardless of maturity) h

14、ave been observed for the yield curve.,Yield Curve Web Sites,Yield Curves, Fixed Income Pricing and Indices Daily Treasury Yield Curve Rates /offices/domestic-finance/debt-management/interest-rate/yield.shtml Bloomberg ,Treasury Yield Curve,Two factors complicate the relationshi

15、p between maturity and yield as indicated by the Treasury yield curve: (1) the yield for on-the-run issues is distorted since these securities can be financed at cheaper rates and, as a result, offer a lower yield than in the absence of this financing advantage and (2) on-the-run Treasury issues and

16、 off-the-run issues have different interest rate reinvestment risks. The yields on Treasury strips of different maturities provide a superior relationship between yield and maturity compared to the on-the-run Treasury yield curve. The yield on a zero-coupon or stripped Treasury security is called th

17、e Treasury spot rate.,Treasury Yield Curve,There are some potential issues with using on-the-run Treasuries to construct a yield curve: Because these are often used as repurchase agreements, the investors (hedge funds) will accept a slightly lower rate because of the cheaper source of financing used

18、 to fund the purchase The level of reinvestment risk can be different for on-the-run and off-the-run Treasuries because of slightly different coupon rates and maturities Because of these potential issues, market watchers look at the relationship between yield and maturity for zero-coupon Treasuries,

19、Term Structure of Interest Rates,The term structure of interest rates is the relationship between maturity and Treasury spot rates. Three theories have been offered to explain the shape of the yield curve: pure expectations theory, liquidity preference theory, and market segmentation theory.,Pure Ex

20、pectations Theory,The pure expectations theory asserts that the market sets yields based solely on expectations for future interest rates. According to the pure expectations theory: (1) a rising term structure reflects an expectation that future short-term rates will rise, (2) a flat term structure

21、reflects an expectation that future short-term rates will be mostly constant, and (3) a falling term structure reflects an expectation that future short-term rates will decline.,Pure Expectations Theory,This is the simplest and most direct link between the yield curve and investors expectations abou

22、t future interest rates because long-term interest rates are linked to expectations about future inflation. The pure expectations theory explains the term structure in terms of expected future short-term interest rates. Under the pure expectations theory, the market will set the yields on a two-year

23、 bond so that the returns on the bond are equal to the return on a one-year bond plus the expected return on a one-year bond purchased one year from today, etc.,Pure Expectations Theory,Under this theory, when the term structure is upward sloping, the implication is that future short-term rates are

24、expected to rise. When the term structure is downward sloping, future short-term rates are expected to decline. When rates are flat, rates are not expected to change.,Pure Expectations Theory,Irving Fisher is the author of the theory, which is popularly accepted. The notion is that interest rates re

25、flect the sum of a relatively stable real rate of interest plus a premium for expected inflation. The shortcoming of this theory is that it assumes investors are indifferent to interest rate risk and any other factors associated with investing in bonds with different maturities.,Liquidity Preference

26、 Theory,This theory asserts that market participants want to be compensated for the interest rate risk associated with holding longer-term bonds. The longer the maturity, the greater the price volatility. Accordingly, this theory uses the pure expectations theory and adds a yield premium for interes

27、t rate risk. This is the reason given to the question of why yield curves are traditionally upward sloping.,Liquidity Preference Theory,Under this theory, when the term structure is upward sloping, the implication is that rates are expected to rise or will be unchanged (or even fall), but with a yie

28、ld premium for interest rate risk. When the term structure is downward sloping or flat, future short-term rates are expected to decline. This is also called the biased expectations theory.,Market Segmentation Theory,The market segmentation theory asserts that there are different maturity sectors of

29、the yield curve and that each maturity sector is independent or segmented from the other maturity sectors. Within each maturity sector, the interest rate is determined by the supply and demand for funds. According to the market segmentation theory, any shape is possible for the yield curve.,Market S

30、egmentation Theory,Under this theory, it is argued that the different maturity sectors of the yield curve are influenced heavily by the forces of supply and demand. In other words, each maturity sector or segmented market is independent. It is thought that there are two groups: Bond investors who ma

31、nage funds versus a broad-based bond market index. Bond managers who concern themselves with matching the maturities of the liabilities (This follows the basic principle of asset-liability management). This theory has strong support since regulations force many market participations to hold bonds of

32、 a fixed maturity and risk (i.e. investment grade). Also, certain foreign investors favor certain maturities (i.e. 10 year Treasuries). This supports a term structure of any shape and is not contradictory of the other theories because within each sector the bond managers may act rationally. It expla

33、ins how term structures can be humped.,Treasury Strips,Even though the Department of the Treasury does not issue zero-coupon bonds with maturities greater than one year, government dealers synthetically create zero-coupon securities by separating the coupon and principal payments. These zero-coupon

34、bonds have no reinvestment risk. Therefore, these become purer measures of yield and maturity and are used to measure the Treasury yield curve. The yield on a Treasury zero-coupon is known as the spot rate. The relationship between maturity and Treasury spot rates is known as the term structure of i

35、nterest rates.,Non-Treasury Securities,Even though the use of the non-spot rate Treasury yields has some slight imperfections, they are often used to compute the yield spread versus non-Treasury securities. Because non-Treasury sectors of the bond market offer a higher yield than Treasuries, these a

36、re referred to as spread sectors. The non-Treasury debt offering are referred to as spread products.,Yield Spreads,Despite the imperfections of the Treasury yield curve as a benchmark for the minimum interest rate that an investor requires for investing in a non-Treasury security, it is common to re

37、fer to a non-Treasury securitys additional yield over the nearest maturity on-the-run Treasury issue as the yield spread. The yield spread can be computed in three ways: (1) the difference between the yield on two bonds or bond sectors (called the absolute yield spread), (2) the difference in yields

38、 as a percentage of the benchmark yield (called the relative yield spread), and (3) the ratio of the yield relative to the benchmark yield (called the yield ratio).,Yield Spreads,Yield spread (measured in basis points) is the difference between any two bond issues and is computed as follows: Yield s

39、pread = yield on Bond 1 yield on Bond 2 When the second bond is a benchmark (i.e. Treasury), the yield spread is referred to as the absolute yield spread it is measured in basis points (bps). To measure yield of a bond versus the reference bond, the relative yield spread is computed: Relative yield

40、spread = Yield spread / Yield on Bond 2 Another measure of relative yield spread is to compute the yield ratio: Yield ratio = Yield on Bond 1 / Yield on Bond 2,Yield Spreads,It is useful to compute relative yield spreads because the magnitude of the spread is affected by the level of interest rates:

41、 View examples of differences in yield spreads across time Yield spreads are key to active bond management Bond management strategies focus on understanding the differences in yield spreads and assessing the factors that cause the yield spread to widen or narrow Bond managers forecast how yield spre

42、ads will change across sectors, economic changes, across the investment horizon (maturities), etc.,Intermarket Yield Spreads,An intermarket yield spread is the yield spread between two securities with the same maturity in two different sectors of the bond market. The most common intermarket sector s

43、pread calculated is the yield spread between the yield on a security in a non-Treasury market sector and a Treasury security with the same maturity.,Intramarket Yield Spreads,An intramarket sector spread is the yield spread between two issues within the same market sector.,Yield Spreads Within and A

44、cross Sectors and Markets,The bond market is arranged into sectors based on the type of issuer, for example: Government U.S. Treasury Agencies Municipality State City School District Other Corporate Asset- and Mortgage-backed Foreign,Yield Spreads Within and Across Sectors and Markets,Different sect

45、ors have different risk and return characteristics Market sectors can be further divided to reflect common economic characteristics: Industrial Utility Finance Banks Asset- and mortgage-backed securities also have their unique sub-sector classifications,Yield Spreads Within and Across Sectors and Ma

46、rkets,The yield spreads between yields offered in two different sectors is called the intermarket sector spread This is also always measured versus the Treasury yield The yield spread differential within a market sector is the intramarket sector spread This spread typically increases with maturity Y

47、ield curves are computed for a given sector, much like the Treasury yield curve,Issuer Specific Yield Spreads,An issuer specific yield curve can be computed given the yield spread, by maturity, for an issuer and the yield for on-the-run Treasury securities. The factors other than maturity that affec

48、t the intermarket and intramarket yield spreads are (1) the relative credit risk of the two issues; (2) the presence of embedded options; (3) the relative liquidity of the two issues; and, (4) the taxability of the interest.,Credit Spreads,The yield spread between Treasury and non-Treasury bonds tha

49、t are identical in all respects except credit rating is referred to as the credit or quality spread.,Credit Spreads,A credit spread or quality spread is the yield spread between a non-Treasury security and a Treasury security that are identical in all respects except for credit rating. Some market p

50、articipants argue that credit spreads between corporates and Treasuries change systematically because of changes in economic prospectswidening in a declining economy (flight to quality) and narrowing in an expanding economy.,Credit Spreads,Credit spreads between Treasury and corporate bonds change s

51、ystematically with changes in the overall economy. Credit spreads widen (narrow) in a declining (expanding) economy. Historical examples Exhibit 4 shows the changes in credit spreads since 1919 The spread is measured as the difference between the Baa and Aaa rated corporate debt The relationship bet

52、ween macro-economic conditions and yield spread is clearly shown in the exhibit,Credit Spreads,Embedded Options,Generally investors require a larger spread to a comparable Treasury security for issues with an embedded option favorable to the issuer, and a smaller spread for an issue with an embedded

53、 option favorable to the investor. For mortgage-backed securities, one reason for the increased yield spread relative to a comparable Treasury security is exposure to prepayment risk. The option-adjusted spread of a security seeks to measure the yield spread after adjusting for embedded options.,Emb

54、edded Options,Embedded options (such as the call provision) effect the yield of a bond and effects the yield spread Mortgage-backed securities have prepayment risk effecting the yield spread Reported yield spreads do not adjust for embedded options (these are raw or nominal yield spreads). The adjus

55、ted yield spread is called the option-adjusted spread (OAS).,Liquidity and Taxability,The amount of liquidity (breadth and depth of the market) can affect the yield spread. Differences between the yields of off- and on-the-run Treasuries is an example. Because on-the-run is in greater demand, the pr

56、ice is slightly higher and yield lower than off-the-run. The size of the issue affects liquidity, with larger issues having greater liquidity In the U.S., income tax is collected on the interest income except for qualified municipal bonds,Liquidity,A yield spread exists due to the difference in the

57、perceived liquidity of two issues. One factor that affects liquidity (and therefore the yield spread) is the size of an issuethe larger the issue, the greater the liquidity relative to a smaller issue, and the greater the liquidity, the lower the yield spread.,Taxability,Because of the tax-exempt fe

58、atures of municipal bonds, the yield is less than similar maturities of other bonds The yield ratio is used to compare the yields of tax-exempt and similar maturity Treasuries (Exhibit 6) The yield ratio for municipal bonds will change depending upon changes in the individual income tax rate The hig

59、her the tax rate, the more attractive the tax exempt bond and the lower the yield ratio,Taxability,Because of the tax-exempt feature of municipal bonds, the yield on municipal bonds is less than that on Treasuries with the same maturity. The difference in yield between tax-exempt securities and Treasury securities is typically measured in terms of a yield ratiothe yield on a tax-exempt security as a percentage of the yield on a comparable Treasury security. The after-tax yield is computed by multiplying the pre-tax yield by one minus the marginal tax rate. In the tax-exempt bond market, the