The bond spread or yield spread, refers to the difference in the yield on two different bonds or two classes of bonds.
Investors use the spread as in indication of the relative pricing or valuation of a bond. If one bond yields 3% and another yields 1%, the yield spread is 2% -- which typically would be expressed as ‘200 basis points’.
The wider the spread between two bonds, or two classes of bonds, the greater the valuation differential. In particular, the bond or class of bond with the higher yield is considered riskier, with the higher yield being compensation to investors for this risk differential.
Bear in mind that the price of a bond moves inversely with its yield. So, when investors consider a bond to have become riskier and react by selling their holdings, the price of the bond declines, and thus its yield (the ratio of its coupon to this lower price) increases. If the pricing of other bonds remains unchanged in this scenario, the yield spread of this bond increases.
Typically, the yield on a bond issued by a company would be higher than the yield on a government bond of the same maturity, as governments tend to have better investment ratings (they are considered more likely to be able to service their debt) than private businesses. The riskier the issuing company is perceived to be, the wider its bond yield spread will be relative to government bonds.
Yields spreads can give market observers a quick snapshot of sentiment. For instance, at times when investors become risk-averse and favor safer bonds, yield spreads widen: this includes spreads between high yield debt and investment grade debt, or between emerging market debt and debt issued by developed countries.
Yield differentials between bonds of the same class but with different maturities are also helpful indicators of sentiment. Longer-dated debt usually is considered riskier than short-dated debt, owing to the maturity risk premium. So, long-term debt typically would have a positive yield spread relative to short-term debt.
But, at turning points in the market cycle, when a recession is priced in and fear of the immediate future prevails, investors shun shorter-term debt in favor of longer-term debt, thus pushing up short-term yields and dampening long-term yields. The yield spread would then shrink and may even turn negative (see Inverted yield curve).