Credit Spreads

A yield curve displays yields across different maturities. On the other hand, a yield or credit spread considers yields between different credit qualities.

A credit spread shows the difference in yields between high-rated and low-rated bonds, or between Treasury and junk bonds.

If investors demand a much greater yield on low-rated bonds than on high-rated bonds, that's a negative indicator for the economy. If investors don't demand a much higher yield on the low-rated bonds, that means they are confident about issuers' ability to repay, which is a positive indicator. So, when the yield spread narrows, that is good news, while, on the other hand, when the yield spread widens, there could be trouble up ahead.

If the 10-year US. Treasury note currently yields 3%, while 10-year junk bonds yield 8%, the spread or "risk premium" is 5 percentage points. Investors are demanding a "risk premium" of 5 extra percentage points (500 basis points) of yield to buy the riskier bonds.

If the T-Note is yielding 2% while high-yield bonds yield 5%, the credit spread has narrowed to just three percentage points, implying more confidence on the part of bond investors.


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