Bond Spreads
Period Ending 02/29/2008
Chart of the Week for March 20 - March 27, 2008
Bond yields generally reflect current interest rates plus a risk premium and are historically higher for those borrowers that have a greater probability of defaulting on their debt. For instance, a borrower such as the U.S. Treasury can attract investors with a lower yield since the U.S. Government is assumed to have no default risk. Other borrowers typically offer investors a higher yield to compensate them for the additional risk they are taking.
Recently, the spread or yield difference between lower risk bonds and higher risk bonds has increased as illustrated in the chart above. In this example, lower risk bonds are represented by the LB U.S. Treasury Index which contains public obligations with a remaining maturity of one year or more. Higher risk bonds are represented by the LB U.S. Corporate Investment Grade Index which contains corporate credits rated BBB or higher and the LB Asset Backed Securities Index covering the following security types: credit card, auto, home equity, utility and manufactured housing. The spread increase has been driven by a flight to quality as demand for lower risk bonds (UST) has increased driving up their prices and significantly pushing down their yields. Higher risk bonds (CORP and ABS) have experienced lower demand so, the yield spread has increased. For example, the yield spread on March 30, 2007 stood at 0.51%. The yield spread increased to 3.26% on February 29, 2008 providing evidence that investors are reevaluating the yield to risk relationship due to recent credit market concerns.
Yield spreads change over time with market conditions, and the relative risk assumed by bond investors likewise changes. It is difficult to determine what factors are driving credit markets throughout market cycles and what their ultimate impact will be on investment returns, so it is important to remain diversified both in terms of equity and bond exposure.
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