Yield spread

Also called ‘credit spread’, the term refers to the difference between yields of different debt instruments of varying maturities, credit ratings, issuers, or risk levels.

The spread is calculated by deducting the return of one instrument, from the return of the other instrument, the resulting difference most commonly being denoted in basis points (bps) or percentage points.

Yield spread can serve as an indication of profitability for a lender extending a loan to an individual borrower. 

In the case of consumer loans, such as home mortgages, an important yield spread is the disparity between the actual interest rate paid by the borrower for a specific loan and the (lower) interest rate that corresponds to the borrower’s creditworthiness.

For example, if a borrower qualifies for a loan with a 5% interest rate based on their credit, but chooses a loan with a 6% interest rate, the lender earns an extra profit of 1% through the yield spread (assuming the credit risk remains the same). Lenders often offer yield spread premiums to brokers who find borrowers willing to accept higher yield spreads as part of their strategic approach.

Yield spreads are commonly used when discussing the yields of US Treasuries, which are known as the credit spread. 

To illustrate, if the yield of a five-year Treasury bond is 5% and the yield of a 30-year Treasury bond is 6%, the yield spread between these two bonds is 1%. When the 30-year bond is trading at 6%, historical analysis of yield spreads suggests that the five-year bond should ideally be trading around 1%. Therefore, the current yield of 5% for the five-year bond appears quite attractive in comparison.