The world of investments can be divided into two categories -- risk free and risky. Investors are compensated according to the risk they take: The greater the risk, the juicier the reward. The high yield spread measures the extra return that investors receive when buying risky corporate bonds instead of risk-free U.S. government debt.
One of the major sources of risk in bonds is credit quality. Investors naturally worry whether a company will be able to repay its debts. The arbiters of bond credit quality are known as rating agencies; the three major ones are Moody's, Standard and Poor's and Fitch. Their job is to assign ratings, or votes of confidence, to different bonds. For example, S&P assigns ratings of "AAA" to the bonds that it believes are extremely likely to be repaid but ratings of "BBB" to companies that are vulnerable to adverse economic conditions.
Duration, Liquidity and Callability
Besides credit quality, investors are interested in other bond features that increase risk. Duration risk reflects how long it takes for investors to receive their money; bonds with higher durations carry more risk, because their price can swing when the Federal Reserve changes interest rates. Liquidity is another factor, or how easily a bond can be bought and sold without sacrificing price. Generally speaking, bonds that are thinly traded face higher liquidity risk. Investors also consider a bond's callability risk, or the possibility that the bond is repaid ahead of schedule by the borrower.
High Yield Spread
All of the bond's different risks -- credit quality, duration, liquidity, callability -- are factored into its high yield spread. The spread is calculated as the difference between the yield on the corporate bond compared to a U.S. Treasury security of the same maturity. Suppose that a AAA-rated 10-year bond by General Electric carries a yield of 5.5 percent. If the yield on the 10-year U.S. Treasury bond is 3.5 percent, the spread is 2 percent, or 5.5 minus 3.5. The 2 percent spread represents the risk premium that investors demand to invest in GE's 10-year bond.
A number of sources provide real-time information on high yield spreads, including financial newspapers, websites and television programs. An important aspect of spreads is how they evolve over time. Spreads narrow when investors gain confidence and widen when they grow concerned. Fortunately, historical spread information is available; one such index -- the BofA Merrill Lynch U.S. High Yield Master II Option-Adjusted Spread -- can be accessed on the website of the Federal Reserve Bank of St. Louis.
Giulio Rocca's background is in investment banking and management consulting, including advising Fortune 500 companies on mergers and acquisitions and corporate strategy. He also founded GradSchoolHeaven.com, an online resource for graduate school applicants. He holds a Bachelor of Science in economics from the University of Pennsylvania, a Master of Arts in English from the University of Hawaii at Manoa, and a Master of Business Administration from Harvard University.