Understanding Bond Spread

Bond spread is a mathematical illustration of the difference between the interest rate of two bonds. Traders and investors use the bond spread of two separate bonds to determine which is riskier, safer or likely to pay higher returns. While the concept of a bond spread is very simple, deeper analysis of spreads over time can reveal trends in various bond markets. This can help investors understand the likely payout of purchasing and holding a bond to maturity or selling a bond in the future.

Considering Risk

An investor must consider the likelihood the bonds will maintain their value while held and pay off upon maturity. The Federal Government, which retains the power to print money, is typically the safest borrower for a purchaser to contract with. It is not possible the government will default on the loan. Local governments have a higher chance of default, and corporations tend to carry the highest possibility. This will be reflected in changing prices of the bond, but it will not be reflected in bond spread.

Calculating Bond Spread

Calculating a current bond spread is a matter of simple subtraction. For example, start with a government bond that pays 7% interest over 10 years and compare it to a corporate bond that pays 7.9% interest over the same period. 7.9% minus 7% is .9%. This is typically expressed as "100 basis points." All things being equal, the corporate bond would be more valuable to either hold or trade. The higher interest rate means it would pay greater discounts each term. It also means selling the bond for a profit will be easier if the prices of the two bonds are the same. 

Using Bond Spread Over Time

Unfortunately, comparing the spread of two bonds on one day alone is not sufficient to understand which is the better deal. The interest rate on any bond will fluctuate, whether daily, monthly or annually. This means the bond spread on two bonds will change over time. Computer modeling allows investors to track the spread of two or more bonds over a very long period of time. They will find some bonds hold their interest rate more than others. Since both bonds will be subject to the same market conditions, however, they should follow a slightly mirrored pattern. The bond spread should remain relatively constant within a few standard deviations. If it does not, then the investor will typically find one very erratic bond, and this is a highly risky purchase.

Using Bond Spread to Make Decisions

Once risk is factored in, bond spread is a good way to compare two bonds and make a decision. For example, if a government bond carries little risk but has an 80-basis-point spread separating it from a corporate bond with medium risk, some investors will choose the corporate bond. Bonds, like stocks, carry more reward for more risk. The bond spread shows the likely reward on a stock alone, and the risk is calculated separately. Holding a diverse portfolio of bonds can balance some of the risk and provide good metrics for trading. 

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