UNDERSTANDING YIELD SPREADS
IV. YIELDS ON NON-TREASURY SECURITIES
Despite the imperfections of the Treasury yield curve as a benchmark for the minimum interest rate that an investor requires for investing in a non-Treasury security, it is commonplace to refer to the additional yield over the benchmark Treasury issue of the same maturity as the yield spread. In fact, because non-Treasury sectors of the fixed income market offer a yield spread to Treasury securities, non-Treasury sectors are commonly referred to asspread sectors and non-Treasury securities in these sectors are referred to asspread products.
A. Measuring Yield Spreads
While it is common to talk about spreads relative to a Treasury security of the same maturity, a yield spread between any two bond issues can be easily computed. In general, the yield spread between any two bond issues, bond X and bond Y, is computed as follows:
yield spread=yield on bond X−yield on bond Y
where bond Y is considered the reference bond (or benchmark) against which bond X is measured.
When a yield spread is computed in this manner it is referred to as anabsolute yield spreadand it is measured in basis points. For example, on February 8, 2002, the yield on the 10-year on-the-run Treasury issue was 4.88% and the yield on a single A rated 10-year industrial bond was 6.24%. If bond X is the 10-year industrial bond and bond Y is the 10-year on-the-run Treasury issue, the absolute yield spread was:
yield spread=6.24%−4.88%=1.36% or 136 basis points
Unless otherwise specified, yield spreads are typically measured in this way. Yield spreads can also be measured on a relative basis by taking the ratio of the yield spread to the yield of the reference bond. This is called arelative yield spreadand is computed as shown below, assuming that the reference bond is bond Y:
relative yield spread= yield on bond X−yield on bond Y yield on bond Y
Chapter 4 Understanding Yield Spreads 83
Sometimes bonds are compared in terms of ayield ratio, the quotient of two bond yields, as shown below:
yield ratio=yield on bond X yield on bond Y
Typically, in the U.S. bond market when these measures are computed, bond Y (the reference bond) is a Treasury issue. In that case, the equations for the yield spread measures are as follows:
absolute yield spread = yield on bond X−yield of on-the-run Treasury relative yield spread = yield on bond X−yield of on-the-run Treasury
yield of on-the-run Treasury
yield ratio = yield on bond X
yield of on-the-run Treasury
For the above example comparing the yields on the 10-year single A rated industrial bond and the 10-year on-the-run Treasury, the relative yield spread and yield ratio are computed below:
absolute yield spread = 6.24%−4.88%=1.36%=136 basis points relative yield spread = 6.24% − 4.88%
4.88% =0.279=27.9%
yield ratio = 6.24%
4.88%=1.279
The reason for computing yield spreads in terms of a relative yield spread or a yield ratio is that the magnitude of the yield spread is affected by the level of interest rates. For example, in 1957 the yield on Treasuries was about 3%. At that time, the absolute yield spread between triple B rated utility bonds and Treasuries was 40 basis points. This was a relative yield spread of 13% (0.40% divided by 3%). However, when the yield on Treasuries exceeded 10% in 1985, an absolute yield spread of 40 basis points would have meant a relative yield spread of only 4% (0.40% divided by 10%). Consequently, in 1985 an absolute yield spread greater than 40 basis points would have been required in order to produce a similar relative yield spread.
In this chapter, we will focus on the yield spread as most commonly measured, the absolute yield spread. So, when we refer to yield spread, we mean absolute yield spread.
Whether we measure the yield spread as an absolute yield spread, a relative yield spread, or a yield ratio, the question to answer is what causes the yield spread between two bond issues. Basically, active bond portfolio strategies involve assessing the factors that cause the yield spread, forecasting how that yield spread may change over an investment horizon, and taking a position to capitalize on that forecast.
B. Intermarket Sector Spreads and Intramarket Spreads
The bond market is classified into sectors based on the type of issuer. In the United States, these sectors include the U.S. government sector, the U.S. government agencies sector, the municipal sector, the corporate sector, the mortgage-backed securities sector, the asset-backed
securities sector, and the foreign (sovereign, supranational, and corporate) sector. Different sectors are generally perceived as offering different risks and rewards.
The major market sectors are further divided into sub-sectors reflecting common economic characteristics. For example, within the corporate sector, the subsectors are: (1) industrial companies, (2) utility companies, (3) finance companies, and (4) banks. In the market for asset-backed securities, the sub-sectors are based on the type of collateral backing the security.
The major types are securities backed by pools of (1) credit card receivables, (2) home equity loans, (3) automobile loans, (4) manufactured housing loans, and (5) student loans. Excluding the Treasury market sector, the other market sectors have a wide range of issuers, each with different abilities to satisfy their contractual obligations. Therefore, a key feature of a debt obligation is the nature of the issuer.
The yield spread between the yields offered in two sectors of the bond market with the same maturity is referred to as anintermarket sector spread. The most common intermarket sector spread calculated by market participants is the yield spread between a non-Treasury sector and Treasury securities with the same maturity.
The yield spread between two issues within a market sector is called an intramarket sector spread. As with Treasury securities, a yield curve can be estimated for a given issuer.
The yield spread typically increases with maturity. The yield spreads for a given issuer can be added to the yield for the corresponding maturity of the on-the-run Treasury issue. The resulting yield curve is then anissuer’s on-the-run yield curve.
The factors other than maturity that affect the intermarket and intramarket yield spreads are (1) the relative credit risk of the two issues, (2) the presence of embedded options, (3) the liquidity of the two issues, and (4) the taxability of interest received by investors.
C. Credit Spreads
The yield spread between non-Treasury securities and Treasury securities that are identical in all respects except for credit rating is referred to as a credit spread or quality spread.
‘‘Identical in all respects except credit rating’’ means that the maturities are the same and that there are no embedded options.
For example, Exhibit 3 shows information on the yield spread within the corporate sector by credit rating and maturity, for the 90-day period ending February 8, 2002. The high, low, and average spreads for the 90-day period are reported. Note that the lower the credit rating, the higher the credit spread. Also note that, for a given sector of the corporate market and a given credit rating, the credit spread increases with maturity.
It is argued that credit spreads between corporates and Treasuries change systematically with changes in the economy. Credit spreads widen (i.e., become larger) in a declining or contracting economy and narrow (i.e., become smaller) during economic expansion. The economic rationale is that, in a declining or contracting economy, corporations experience declines in revenue and cash flow, making it more difficult for corporate issuers to service their contractual debt obligations. To induce investors to hold spread products as credit quality deteriorates, the credit spread widens. The widening occurs as investors sell off corporates and invest the proceeds in Treasury securities (popularly referred to as a ‘‘flight to quality’’). The converse is that, during economic expansion and brisk economic activity, revenue and cash flow increase, increasing the likelihood that corporate issuers will have the capacity to service their contractual debt obligations.
Exhibit 4 provides evidence of the impact of the business cycle on credit spreads since 1919. The credit spread in the exhibit is the difference between Baa rated and Aaa rated
Chapter 4 Understanding Yield Spreads 85
EXHIBIT 3 Credit Spreads (in Basis Points) in the Corporate Sector on February 8, 2002
AA—90-day A—90-day BBB—90-day
Maturity (years) High Low Avg High Low Avg High Low Avg
Industrials
5 87 58 72 135 85 112 162 117 140
10 102 73 90 158 109 134 180 133 156
30 114 93 106 170 132 152 199 154 175
Utilities
5 140 0 103 153 112 134 200 163 184
10 160 0 121 168 132 153 220 182 204
30 175 0 132 188 151 171 240 200 222
Finance
5 103 55 86 233 177 198
10 125 78 103 253 170 209
30 148 100 130 253 207 228
Banks
5 97 60 81 113 83 100
10 120 78 95 127 92 110
30 138 105 121 170 127 145
Source: Abstracted fromGlobal Relative Value, Lehman Brothers, Fixed Income Research, February 11, 2002, p. 133.
EXHIBIT 4 Credit Spreads Between Baa and Aaa Corporate Bonds Over the Business Cycle Since 1919
1920
0 1 2 3 4
(%)
5 6
1920 1930 1930 1940 1940 1940 1950 1950 1960 1960 1960 1970 1970 1980 1980 1980 1990 1990 2000 2000
Shaded areas=economic recession as defined by the NBER.
Source: Exhibit 1 in Leland E. Crabbe and Frank J. Fabozzi,Managing a Corporate Portfolio(Hoboken, NJ: John Wiley & Sons, 2002), p. 154.
corporate bonds; the shaded areas in the exhibit represent periods of economic recession as defined by the National Bureau of Economic Research (NBER). In general, corporate credit spreads tightened during the early stages of economic expansion, and spreads widened sharply during economic recessions. In fact, spreads typically begin to widen before the official beginning of an economic recession.8
Some market observers use the yield spread between issuers in cyclical and non-cyclical industry sectors as a proxy for yield spreads due to expected economic conditions. The rationale is as follows. While companies in both cyclical and non-cyclical industries are adversely affected by expectations of a recession, the impact is greater for cyclical industries. As a result, the yield spread between issuers in cyclical and non-cyclical industry sectors will widen with expectations of a contracting economy.
D. Including Embedded Options
It is not uncommon for a bond issue to include a provision that gives either the issuer and/or the bondholder an option to take some action against the other party. The most common type of option in a bond issue is the call provision that grants the issuer the right to retire the debt, fully or partially, before the scheduled maturity date.
The presence of an embedded option has an effect on both the yield spread of an issue relative to a Treasury security and the yield spread relative to otherwise comparable issues that do not have an embedded option. In general, investors require a larger yield spread to a comparable Treasury security for an issue with an embedded option that is favorable to the issuer (e.g. a call option) than for an issue without such an option. In contrast, market participants require a smaller yield spread to a comparable Treasury security for an issue with an embedded option that is favorable to the investor (e.g., put option or conversion option).
In fact, for a bond with an option favorable to an investor, the interest rate may be less than that on a comparable Treasury security.
Even for callable bonds, the yield spread depends on the type of call feature. For a callable bond with a deferred call, the longer the deferred call period, the greater the call protection provided to the investor. Thus, all other factors equal, the longer the deferred call period, the lower the yield spread attributable to the call feature.
A major part of the bond market is the mortgage-backed securities sector.9These securities expose an investor to prepayment risk and the yield spread between a mortgage-backed security and a comparable Treasury security reflects this prepayment risk. To see this, consider a basic mortgage-backed security called a Ginnie Mae passthrough security. This security is backed by the full faith and credit of the U.S. government. Consequently, the yield spread between a Ginnie Mae passthrough security and a comparable Treasury security is not due to credit risk. Rather, it is primarily due to prepayment risk. For example, Exhibit 5 reports the yield on 30-year Ginnie Mae passthrough securities with different coupon rates. The first issue to be addressed is the maturity of the comparable Treasury issue against which the Ginnie Mae should be benchmarked in order to calculate a yield spread. This is an issue because a mortgage passthrough security is an amortizing security that repays principal over time rather than just at the stated maturity date (30 years in our illustration). Consequently, while the
8For a further discussion and evidence regarding business cycles and credit spreads, see Chapter 10 in Leland E. Crabbe and Frank J. Fabozzi,Managing a Corporate Portfolio(Hoboken, NJ: John Wiley &
Sons, 2002).
9The mortgage-backed securities sector is often referred to as simply the ‘‘mortgage sector.’’
Chapter 4 Understanding Yield Spreads 87
EXHIBIT 5 Yield Spreads and Option-Adjusted Spread (OAS) for Ginnie Mae 30-Year Passthrough Securities (February 8, 2002)
Coupon Yield Benchmark OAS on 90-Day OAS (bps)
rate (%) spread (bps) Treasury 2/8/02 (bps) High Low Avg
6.5 203 5 year 52 75 46 59
7.0 212 5 year 57 83 54 65
7.5 155 3 year 63 94 62 74
8.0 105 3 year 73 108 73 88
9.0 244 2 year 131 160 124 139
Source: Abstracted fromGlobal Relative Value,Lehman Brothers, Fixed Income Research, February 11, 2002, p. 132.
stated maturity of a Ginnie Mae passthrough is 30 years, its yield should not be compared to the yield on a 30-year Treasury issue. For now, you can see that the Treasury benchmark in Exhibit 5 depends on the coupon rate. The yield spread, shown in the second column, depends on the coupon rate.
In general, when a yield spread is cited for an issue that is callable, part of the spread reflects the risk associated with the embedded option. Reported yield spreads do not adjust for embedded options. The raw yield spreads are sometimes referred to as nominal spreads—nominal in the sense that the value of embedded options has not been removed in computing an adjusted yield spread. The yield spread that adjusts for the embedded option is OAS.
The last four columns in Exhibit 5 show Lehman Brothers’ estimate of the option-adjusted spread for the 30-year Ginnie Mae passthroughs shown in the exhibit—the option-adjusted spread on February 8, 2002 and for the prior 90-day period (high, low, and average). The nominal spread is the yield spread shown in the second column. Notice that the option- adjusted spread is considerably less than the nominal spread. For example, for the 7.5% coupon issue the nominal spread is 155 basis points. After adjusting for the prepayment risk (i.e., the embedded option), the spread as measured by the option-adjusted spread is considerably less, 63 basis points.
E. Liquidity
Even within the Treasury market, a yield spread exists between off-the-run Treasury issues and on-the-run Treasury issues of similar maturity due to differences in liquidity and the effects of the repo market. Similarly, in the spread sectors, generic on-the-run yield curves can be estimated and the liquidity spread due to an off-the-run issue can be computed.
A Lehman Brother’s study found that one factor that affects liquidity (and therefore the yield spread) is the size of an issue—the larger the issue, the greater the liquidity relative to a smaller issue, and the greater the liquidity, the lower the yield spread.10
F. Taxability of Interest Income
In the United States, unless exempted under the federal income tax code, interest income is taxable at the federal income tax level. In addition to federal income taxes, state and local taxes may apply to interest income.
10Global Relative Value, Lehman Brothers, Fixed Income Research, June 28, 1999, COR-2 AND 3.
EXHIBIT 6 Yield Ratio for AAA General Obligation Municipal Bonds to U.S. Treasuries of the Same Maturity (February 12, 2002)
Yield on AAA Yield on U.S.
Maturity General obligation (%) Treasury (%) Yield ratio
3 months 1.29 1.72 0.75
6 months 1.41 1.84 0.77
1 year 1.69 2.16 0.78
2 years 2.20 3.02 0.73
3 years 2.68 3.68 0.73
4 years 3.09 4.13 0.75
5 years 3.42 4.42 0.77
7 years 3.86 4.84 0.80
10 years 4.25 4.95 0.86
15 years 4.73 5.78 0.82
20 years 4.90 5.85 0.84
30 years 4.95 5.50 0.90
Source: Bloomberg Financial Markets.
The federal tax code specifically exempts interest income fromqualifiedmunicipal bond issues from taxation.11Because of the tax-exempt feature of these municipal bonds, the yield on municipal bonds is less than that on Treasuries with the same maturity. Exhibit 6 shows this relationship on February 12, 2002, as reported by Bloomberg Financial Markets. The yield ratio shown for municipal bonds is the ratio of AAA general obligation bond yields to yields for the same maturity on-the-run Treasury issue.12
The difference in yield between tax-exempt securities and Treasury securities is typically measured not in terms of the absolute yield spread but as a yield ratio. More specifically, it is measured as the quotient of the yield on a tax-exempt security relative to the yield on a comparable Treasury security. This is reported in Exhibit 6. The yield ratio has changed over time due to changes in tax rates, as well as other factors. The higher the tax rate, the more attractive the tax-exempt feature and the lower the yield ratio.
The U.S. municipal bond market is divided into two bond sectors: general obligation bonds and revenue bonds. For the tax-exempt bond market, the benchmark for calculating yield spreads is not Treasury securities, but rather a generic AAA general obligation yield curve constructed by dealer firms active in the municipal bond market and by data/analytics vendors.
1. After-Tax Yield and Taxable-Equivalent Yield The yield on a taxable bond issue after federal income taxes are paid is called theafter-tax yieldand is computed as follows:
after-tax yield=pre-tax yield×(1−marginal tax rate)
Of course, the marginal tax rate13 varies among investors. For example, suppose a taxable bond issue offers a yield of 5% and is acquired by an investor facing a marginal tax rate of 31%. The after-tax yield would then be:
after-tax yield=0.05×(1−0.31)=0.0345=3.45%
11As explained in Chapter 3, some municipal bonds are taxable.
12Some maturities for Treasury securities shown in the exhibit are not on-the-run issues. These are estimates for the market yields.
13The marginal tax rate is the tax rate at which an additional dollar is taxed.
Chapter 4 Understanding Yield Spreads 89
Alternatively, we can determine the yield that must be offered on a taxable bond issue to give the same after-tax yield as a tax-exempt issue. This yield is called thetaxable-equivalent yieldortax-equivalent yieldand is computed as follows:
taxable-equivalent yield= tax-exempt yield (1−marginal tax rate)
For example, consider an investor facing a 31% marginal tax rate who purchases a tax-exempt issue with a yield of 4%. The taxable-equivalent yield is then:
taxable-equivalent yield= 0.04
(1−0.31)=0.058=5.80%
Notice that the higher the marginal tax rate, the higher the taxable equivalent yield.
For instance, in our last example if the marginal tax rate is 40% rather than 31%, the taxable-equivalent yield would be 6.67% rather than 5.80%, as shown below:
taxable-equivalent yield= 0.04
(1−0.40) =0.0667=6.67%
Some state and local governments tax interest income from bond issues that are exempt from federal income taxes. Some municipalities exempt interest income from all municipal issues from taxation, while others do not. Some states exempt interest income from bonds issued by municipalities within the state but tax the interest income from bonds issued by municipalities outside of the state. The implication is that two municipal securities with the same credit rating and the same maturity may trade at different yield spreads because of the relative demand for bonds of municipalities in different states. For example, in a high income tax state such as New York, the demand for bonds of New York municipalities drives down their yields relative to bonds issued by municipalities in a zero income tax state such as Texas.
G. Technical Factors
At times, deviations from typical yield spreads are caused by temporary imbalances between supply and demand. For example, in the second quarter of 1999, issuers became concerned that the Fed would pursue a policy to increase interest rates. In response, a record issuance of corporate securities resulted in an increase in the yield spread between corporates and Treasuries.
In the municipal market, yield spreads are affected by the temporary oversupply of issues within a market sector. For example, a substantial new issue volume of high-grade state general obligation bonds may tend to decrease the yield spread between high-grade and low-grade revenue bonds. In a weak market environment, it is easier for high-grade municipal bonds to come to market than for weaker credits. So at times high grades flood weak markets even when there is a relative scarcity of medium- and low-grade municipal bond issues.
Since technical factors cause temporary misalignments of the yield spread relationship, some investors look at the forward calendar of planned offerings to project the impact on future yield spreads. Some corporate analysts identify the risk of yield spread changes due to the supply of new issues when evaluating issuers or sectors.