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Evaluating Yield Spreads

The prior tutorial introduced the U.S. Treasury yield curve. In addition to yield measurements, investors can evaluate a bond based on its yield spread, or the difference between the bond’s yield-to-maturity and the prevailing yield offered by on-the-run U.S. Treasuries with the same maturity. Treasuries are considered to be yield benchmarks, because they are virtually free of default risk. Investors use yield spreads to compare the risk premiums of various investment prospects. There are two measurements of yield spread: Absolute Yield Spread, and Relative Yield Spread.

Absolute Yield Spread

Absolute Yield Spread is simply the difference between a bond’s yield-to-maturity and the yield on a comparable treasury security with the same maturity. Absolute Yield Spread can be calculated using the following formula:

Absolute Yield Spread = Bond’s YTM - Comparable Treasury Yield

Consider the following example: Calculate the Absolute Yield Spread of a coupon bond with a yield to maturity of 7.0% if the yield on a comparable treasury bond with the same maturity is 5.8%.

Absolute Yield Spread = 7% - 5.8% = 1.2%

Relative Yield Spread

Relative Yield Spread is a measurement of the relative difference between a bond’s yield-to-maturity and a comparable treasury security with the same maturity. Relative Yield Spread can be derived from the following formula:

Relative Yield Spread = (YTM/Comp. Treasury Yield)-1

Consider the following example: Calculate the relative yield spread of a coupon bond with a yield-to-maturity of 6.4% if the yield on a comparable treasury bond with the same maturity is 5.2%.

Relative Yield Spread = (6.4%/5.2%) -1 = 23%

Questions:

1. Calculate both the absolute yield spread and the relative yield spread of a coupon bond with a yield to maturity of 6% if the yield on a comparable treasury bond with the same maturity is 4.1%.

2. Calculate both the absolute yield spread and the relative yield spread of a coupon bond with a yield to maturity of 5% if the yield on a comparable treasury bond with the same maturity is 4.5%.

Answers:

1. Absolute Yield Spread = 6% - 4.1% = 1.9%
Relative Yield Spread = (6%/4.1%) -1 = 46.34%

2. Absolute Yield Spread = 5% - 4.5% = 0.5%
Relative Yield Spread = (5%/4.5%) -1 = 11.11%