faEven though the way most investors discuss spreads is based on a Treasury security with the same maturity as the one it is being compared to, an investor can also talk about spreads between any two bonds with the following measures:
1. Absolute Yield Spread
This is the way most spreads are measured in the market. This spread measures the difference in spread between two bonds in terms of basis points.
The equation is: Yield Spread = Yield on Bond A - Yield on Bond B
2. Relative Yield Spread
This ratio measures the yield spread relative to the reference bond.
This equation is: Relative Yield Spread = Yield on bond A - Yield on Bond B/ Yield on Bond B
3. Yield Ratio
This is just the ratio of the yields between the two bonds.
The equation is: Yield Ratio = Yield on Bond A / Yield on Bond B
Market convention is to use the on-the-run government security as the reference yield or bond. So in the above equations, one would replace Bond B with the comparable government security.
Example: Yield Ratios
We want to compare an IBM five-year bond with a yield of 4.5 % and the on- the-run government five-year with a yield of 3.75%
Absolute Yield Spread = 4.5% - 3.75% = .75% or 75 basis points
Relative Yield Spread = 4.5% - 3.75% / 3.75% = .20 = 20%
Yield Ratio = 4.5% / 3.75% = 1.20
Why Relative Spreads Are Better
Investors may find relative spreads a better measure because they measure the magnitude of the yield spread and the way it is affected by interest-rate levels. While absolute spread may be maintained as rates change, relative spreads will move in or out depending on the level of rates.
Use the IBM and Treasury bond from the previous example, except now assume that yields have increased.
Absolute Yield Spread 5.75% - 5.00% = .75% or 75 basis points. Even though yields have increased the spread is the same. However, the Relative Spread has changed too:
5.75% - 5.00% / 5.00% = .15 or 15%.
This example shows that the relative spread can give an investor a better reading of how spreads are actually moving relative to the generic yield spread.
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