Question

Discuss the current Yield spread and comment on future movements (explain your reasoning with academic references).

Answer 1

• First, let us understand the concept of current yield of a debt instrument: Current yield is the annual income which an investor will receive after holding a security for one full year. It is calculated by the formula, Current yield = Annual income from the security/ Current Market price of the security; The annual income can be either interest or dividends received from the security.
• Current yield spread is nothing but the difference between the current yields of two debt securities with different risk, credit rating and maturities
• It is calculated by subtracting the current yield of one debt instrument from the other
• For example, If a 3-year bond has a current yield of 5% and a 7-year bond has a current yield of 3% then the current yield spread will be 2%
• Spreads are normally stated in "Basis points". From our previous example, we can say that the current yield spread is 200 Basis points or 200Bps or 2%
• When we compare a high-risk bond and a low-risk bond with a treasury bond then the high-risk bond will have a larger current yield spread than the low-risk bond. This is because of the risk premium paid to the investor in the case of high-risk bond for the additional risk he is taking.
• We know that price of a bond and its yield are inversely proportional. Just by analysing the yield spreads, an investor can predict the instrument's price trend.
• Increasing yield spread of two debt from two different sectors shows that one sector is performing better than the other. The current yield spread is increasing then it implies that the market is expecting a huge default risk which is slowing down the economy leading to depression. When the current yield spread is narrowing down, the market is becoming steady and the economy starting to expand.