Anyone who's ever tried to get a mortgage or some other loan might have noticed it costs more for them to get money than it does the federal government or a large bank. These entities pay some of the lowest interest rates in the world, while commercial and private loans are usually several points higher. This difference, generally attributed to the greater risk of the smaller, retail borrower, is an example of a credit or bond spread.
The difference between the yields of two bonds with differing credit ratings is called a bond spread. Most often, the terms refers to the yield on a corporate bond with a certain amount of risk less the yield of a standard risk-free note such as a U.S. Treasury. A bond spread reflects the additional yield that could be earned by an investor from a bond which has a higher risk, and, conversely, the additional cost of borrowing for a higher risk borrower.
Bond spreads are a direct measure of the cost of risk. U.S. Treasuries are perceived to have little or no risk of default. The difference in cost for any other entity to borrow the same amount of money for the same period of time is attributed to the risks involved with recovering the loan. Risk is important to quantify because it is a major component of investor sentiment and the general well-being of the economy. In periods of uncertainty or recession, investors will shun risk, raising bond spreads.
There are many different bond spreads investors monitor regularly. One of the most common is corporate bond spreads, the difference between Treasuries and high-rated corporate paper of similar maturity. Another is junk bond spreads, which shows the perceived risk of so-called junk bonds versus triple-A rated corporate paper. During the credit crisis of 2008, the TED spread, or Treasury to Eurodollar, came to the fore because it showed the high cost of interbank lending as compared to Treasury yields, a major symptom of illiquidity in the financial sector.
Bond spreads are used by investors to plan strategy and make profitable trades. This is particularly true in currency markets, where bond spreads can be an indicator of economy vitality of a country and therefore of the relative value of a currency. Generally speaking, as interest rates rise the value of a currency does as well. This relationship, however, tends to hold true in periods of prosperity when investor accept risk. In periods of risk-aversion, the relationship between bond spreads and currencies tends to collapse as investors pile into the safest assets, driving down yields.
Many factors go into the determination of bond spreads besides default risk, such as liquidity and taxation, but ultimately spreads are forged in free markets through the action of buyers and sellers. This affords the greatest amount of freedom to individual market participants, but can also leave bond spreads susceptible to distortions caused by misconceptions or by the actions of the largest, relatively few but wealthiest traders. Using historical data and establishing normative ranges helps to contextualize movements and isolate trends.