Yield Spreads Over Benchmark Rates

Exxon Mobil issued a 20-year bond that you purchased to help fund your retirement. The bond has a yield to maturity of 8% and you will use spread analysis to evaluate its performance. You begin by comparing the yield of the Exxon Mobil bond to the yield on a risk-free, government security with a similar maturity date. This difference is the __yield spread__. The government bond is defined as the benchmark security. You would prefer to find an on-the-run bond, which is the most actively traded government bond reading close to par value. However, you might have to use an off-the-run bond, which is a seasoned bond offering and has a slightly higher yield.

You have found a 20-year government bond issued within the last month that has a yield of 7%, and a government bond with 20 years until maturity that was issued five years ago with a yield of 7.2%. What is the appropriate spread on the Exxon Mobil bond?

Incorrect. This would be the spread on an off-the-run issue, and this would only be chosen if an on-the-run issue were not available. Using the on-the-run issue, the yield spread would be one percentage point or 0.01, computed as 8% minus 7%.

Correct. Spreads against government bonds will be positive because the Exxon Mobil bond will have credit risk. The 20-year bond issued recently is the on-the-run issue which is always the preferred benchmark. The difference between 8% and 7% is one percentage point, or 0.01.

The benchmark reflects general macroeconomic conditions, such as expected changes in economic growth, business cycles, monetary, and fiscal policies—all of which impact expected inflation rates and expected real rates. When any of these factors change, the benchmark yield will change. The spread reflects factors unique to the specific bond issue, such as changes in bond ratings, tax implications, and liquidity levels. When any of these factors change, the yield on the issue will change causing the spread to change. Certainly both macro and microeconomic factors will have an impact on spreads.

The spread on your Exxon Mobil bond has recently increased by 50 basis points due to a greater drop in the benchmark yield than in the bond's yield. What is the most likely cause of the spread increase?

Yes. When inflation rates fall, the yield on government benchmarks and government bonds will also fall, reflecting investor's new willingness to lend at lower rates. If the benchmark yield falls more than the bond yield, then different reactions to inflation changes is the likely reason.

Incorrect. When federal governments loosen monetary policy, inflation typically increases as banks tend to lend more capital This causes returns on bonds to increase, so this is not consistent with this situation

Incorrect. Additional fiscal policy uncertainty would tend to place upward pressure on interest rates, particularly the benchmark government bond yield. The fiscal policy uncertainty would cause both the benchmark's and your bond's yields to increase, so it's not consistent with this situation

Back to your Exxon Mobil bond. You can use either the G-spread or the I-spread to determine if your bond is fairly priced considering only credit and liquidity risk. Suppose you expect to hold the bond until it matures. What is the more appropriate yield spread measure?

Incorrect. The G-spread includes measures of credit risk, liquidity risk, and especially tax status in this example. So, its use would be less appropriate for the Exxon bond. The goal was to evaluate credit and liquidity risk, which implies an exclusion of evaluating the trigger of a tax liability.

Yes, any time a bondholder is interested in removing tax differentials, the I-spread provides a good measure of credit risk and liquidity risk, as long as the bond is priced close to par value.

Some bonds pay floating rates, so they should have their own unique benchmark. This will be some market reference rate (MRR), which is also useful when computing the I-spread for asset swaps. The spread provides an indication of the bond's credit risk. In practice, analysts tend to use multiple spreads when analyzing fixed income securities.

In summary, [[summary]]

Two additional spread measures you should know are the __G-spread__ and the __I-spread__. The G-spread is defined as the difference between an actual or interpolated government bond and the yield on a specific bond. The I-spread is defined as the difference between the yield on a specific bond and the standard swap rate. The G-spread measure is helpful when comparing liquidity, credit, and any other risks. This includes tax implications of selling bonds at a discount or premium, both between and among bonds. However, the I-spread allows for comparison of just liquidity and credit risks.

What do you think the yield spread measures?

Yes. Your Exxon Mobil bond and a government bond have different risk profiles, since most government issues are not subject to default risk. You're facing credit risk. The calculated yield spread can be referred to as the risk premium because it represents the investor's compensation above the risk-free rate of the government bond.

Incorrect. The yield on the government bond represents the risk-free rate.

Incorrect. Both bonds have the same maturity date.

0.010

0.008

Expected inflation has fallen

Monetary policy has been loosened

Changes in fiscal policy have created additional uncertainty

G-spread

I-spread

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Risk

Risk-free rate

Time to maturity