A bond spread refers to the difference in interest rates paid by two different bonds. Bonds are a form of debt that an investor buys to be paid the interest the borrower pays. Bonds come in many different forms, such as corporate bonds, government bonds and junk bonds. The bonds pay different rates, or amounts of interest, depending on the risk associated with the bond, and a bond spread can thus be used to evaluate and compare the rates of payment of two different bonds.
A bond is essentially a note or debt that one person owes to another. For example, Treasury bonds are bonds issued by the government. The government borrows the money from investors who buy these bonds and then pays it back at a set rate of interest according to a predetermined schedule. The rate of the bond is the interest the government pays, and the maturity date of the bond is the date by which the government must pay back the principal and interest, although if a bond is not cashed at the maturity date then the interest continues to accrue at the same interest rate.
Corporations can also issue bonds, and in such cases, those bonds are for corporate debt. Corporate bonds generally have a slightly higher rate than government bonds, since there is a greater chance that the corporation will default, which means it won't pay the bond back. The rate of a corporate bond is set by the corporation's credit rating. Corporations with better credit ratings can issue lower interest bonds but investors will still buy them because the chances of the corporation defaulting are smaller.
Junk bonds, on the other hand, are the riskiest type of investment with the highest returns or interest rates. Junk bonds are debt purchases of companies that may not pay the bond back because of their low credit rating. The bond spread between a government bond and a junk bond is normally high. A Treasury bond may pay 4 percent, for example, while a junk bond may pay 10 or 11 percent — if the money is paid back.
Investors can use a bond spread to compare and evaluate two bonds. If one bond is much riskier than the other, the bond spread would have to be high for the investment to be worthwhile. This means the risky bond would have to pay a higher interest rate to make taking on the increased risk a good bet for the investor.
