A credit spread is the difference between the yield on one bond and another. For this post, I am going to focus on the spread between risky bonds and government bonds with similar maturity.
A widening spread is when the difference in yield between the two bonds (risky bond yield vs. government bond yield) increases. A narrowing spread is when the difference in yield between the two bonds decreases.
So what do widening and narrowing spreads tell you?
- Credit Stress: Certain spreads (TED, German bunds vs. European Peripherals, Treasuries vs. HY, etc.) can indicate there are problems in the credit market. Widening spreads tend to be a good indicator of this. On flip side, narrowing spreads indicates the credit market is becoming more functional.
- Economic Conditions: Widening spreads between Treasuries and Corporates may forecast that an economic slowdown is on the horizon. On flip side, narrowing spreads may forecast an uptick in the economy is coming.
- Time to Buy? This gets tricky, but as a spread widens so does the buying opportunity. Bond yields and prices move in opposite directions. So if the yield on risky bonds increases relative to the yield on government bonds the price of the risky bonds falls. The lower the price the better the value. On the flip side, narrowing spreads might indicate certain bonds are now pricey.
There are some caveats when it comes to buying on a wide spread, namely that spreads can continue to rise and/or the spread can stay the same, but the yields of both bonds rise.
Regardless of whether or not spreads can provide buy or sell signs, they are certainly a good indicator that deserve attention.
