The bond market is carved into different sectors based on the issuer. Typically, these sectors are:
3. Municipal Securities
4. Corporate Bonds
5. Mortgage Backed Bond
6. Asset Backed Bonds
7. Foreign Bonds
These sectors also can be broken down even further. For example, in the Corporate Sector, issuers can fall into one and sometimes more categories such as industrial, utilities, financials and bank.
Spreads tend to be wider the farther one goes out the curve. Spreads can be based on individual sectors or crossed between them.
Intermarket Sector Spreads
Intermarket sector spreads deal with the yield spreads between two bonds in different sectors of the market. The most popular of these is a non-treasury security as opposed to a comparable treasury security. A comparable treasury security would be one with the same maturity.
Intramarket Sector Spreads
Intramarket sector spreads deal with the yield spread between two bonds in the same market sector. This can be done by developing a yield curve that is similar to the treasury yield curve but instead using the issuers' securities to develop the curve.
Some other factors that affect spreads between bonds besides maturity are credit risk, any options that the bonds may have, the liquidity of the issuers and the tax bracket of investors who receive interest payments.
Credit Spreads and Their Relationship to Economic Activity
A Credit Spread is the yield spread between non-treasury and treasury securities. These are equal in all respects except their individual credit ratings. This means that their maturities are the same and that there are no options thrown into the equation.
It is important to note that spreads increase with maturity and lower credit ratings.
Spreads interact with economic growth or decline in two key ways:
1. Spreads narrow or tighten - When the economy is growing, cash flows are increasing. Therefore, a corporation should have an easier time paying off its debt. Individuals will purchase more non-treasury securities than treasury securities because the increased economic activity reduces the default risk, causing spreads to tighten.
2. Spreads widen - When economy is faltering or slowing down, spreads widen. When this happens, the possibility of defaults increases because cash flows are declining. Individuals will sell or dump non-treasury securities for government securities because there is less of a chance that the government will default on their debt when compared to a corporation. This is also known as a flight to safety.
Options and their Benefits
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