A yield spread is an investment strategy that involves the comparison of two different bond issues that share a common time to maturity. The purpose behind calculating the yield spread is to help the investor determine which bond issue would be the better investment. There are a couple of key factors that help to influence the determination of the yield spread.
First, there is the actual percentage yield on each of the bonds. This will be calculated allowing for the chance of either an early call date on the bonds as well as projections based on both bonds reaching full maturity. Depending on the purchase price, the rate of interest return, and the general stability of the underwriter for the bond, a percentage yield may actually be better for a bond that does not seem to be the best option at first glance.
Next, there is the matter of supply and demand in the general market. Are there peripheral factors that would impact the value of one or both of the bonds before they reach maturity? If so, then the yield spread may reveal that the best strategy is to go with a bond issue that demonstrates a stability to withstand market trends and even unforeseen factors, such as natural disasters.
Last, there is the matter of the credit rating associated with the underlying assets that support the bonds. Yields can be impacted if changes in the worth of debt securities take place. While this is not often the case with bonds, it is a consideration that any long time investor will want to investigate before moving forward with the purchase of the bond issue.
The underlying reason for making use of a yield spread is to obtain the highest return on a bond investment, while still keeping within the comfort zone of the investor as it relates to risk. Once the investor has determined the yield spread of the two bonds under consideration, it is possible to decide if one or even both investment opportunities represent acceptable yields at acceptable risks.
