Lesson 2 of 7
Bonds, yields and spreads
A bond's yield and its spread over a Treasury of the same maturity are the credit market's own running estimate of a company's risk of default.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A bond's price and its yield move in opposite directions: pay less for the same future payment and the yield rises.
- The spread is a bond's yield minus a Treasury's yield of the same maturity, and it is compensation for the risk that the company does not pay.
- A spread can widen for months before an agency acts, because the bond market reprices every day and a rating review does not.
A bond's yield is what its price implies you will earn if it is paid as promised. Set beside a Treasury of the same maturity, the extra yield a company's bond carries is called its spread. That spread is the price the market charges for the chance of not being paid in full.
One company's spread over six quarters, before a downgrade
- Spread over Treasuries
Show the numbers
| Spread over Treasuries | |
|---|---|
| Q1 | 1.5 pts |
| Q2 | 1.6 pts |
| Q3 | 1.8 pts |
| Q4 | 2.3 pts |
| Q5 | 3.1 pts |
| Q6 | 4.0 pts |
Price and yield move opposite ways
A bond is a promise to pay a fixed amount later. Pay less for that same promise today and your return is higher; pay more and it is lower. Price and yield are two ways of stating the same fact about the same bond, and they move in opposite directions by definition, not by any judgement about the company.
One-year bond yield equals Payment at maturity − price paid divided by Price paid.
Example($100 − $95) ÷ $95 = 5.26%
The spread is compensation for risk
A Treasury bond carries the US government's promise, taken as free of default risk. A company's bond carries the same kind of promise from a business that can fail. The spread is its yield minus the Treasury yield of the same maturity. It is what the market demands to hold four things: default risk, the loss if default comes, a premium for bearing both, and the bond's liquidity. A wider spread says the market prices more of that risk into the bond, or values it lower for other reasons. Either way, it is a market's estimate, not a certainty.
What it tells a shareholder
The shares sit behind the bonds in the claims that get paid first. When the bonds price a real chance of default, the claim behind them, the equity, is thin. A spread widening while the share price holds still is two markets disagreeing, and a reason to reread the filings.
Spreads often move before ratings do
Bond prices move as news arrives, even though many issues trade only now and then. Agencies watch continuously but aim for stable ratings and change them rarely. A company's spread can widen for two or three quarters on weakening results before a rating agency changes anything. That is why the market price and the published rating are two different signals, read together rather than as one. A widening spread on its own is not proof that a downgrade is coming. Spreads also move on broad market swings in risk appetite that have nothing to do with any single company.
Check yourself
A bond's price falls while the payment it promises stays the same. What happens to its yield?
- It falls too
- It rises
- It stays the same
Show the answer
Answer: B.
Price and yield move in opposite directions for the same promised payment. Paying less for the same future payment is a higher return.What does a company bond's spread over a Treasury of the same maturity represent?
- The company's dividend yield
- The extra yield the market demands for the company's credit risk
- The company's price to earnings ratio
Show the answer
Answer: B.
The spread isolates the extra yield a company's own risk adds on top of a risk-free Treasury of the same maturity.Why might a company's credit spread widen before its published rating changes?
- Agencies are barred from acting between filings
- Bond prices move with the news; agencies change ratings rarely and aim for stability
- Spreads and ratings always move together
Show the answer
Answer: B.
A rating review runs on a schedule the agency sets. A bond's price, and so its spread, can move well before that review happens.Sources
- Item 15 of Form 10-K: the exhibit index, where indentures (bond terms) and credit agreements are filed.
What this leaves out
- The chart of a spread widening over six quarters is an illustrative shape, not one company's filed history.
- A spread also moves for reasons that are not about the company: the whole bond market can reprice risk at once.
- Nothing here prices any real bond or says what its yield ought to be. Nothing here is advice about any security.