Fixed Income Analysis, Second Edition

CHAPTER 4

UNDERSTANDING YIELD SPREADS

I. INTRODUCTION

The interest rate offered on a particular bond issue depends on the interest rate that can be earned on (1) risk-free instruments and (2) the perceived risks associated with the issue. We refer to the interest rates on risk-free instruments as the “level of interest rates.” The actions of a country’s central bank influence the level of interest rates as does the state of the country’s economy. In the United States, the level of interest rates depends on the state of the economy, the interest rate policies implemented by the Board of Governors of the Federal Reserve Board, and the government’s fiscal policies.

A casual examination of the financial press and dealer quote sheets shows a wide range of interest rates reported at any given point in time. Why are there differences in interest rates among debt instruments? We provided information on this topic in Chapters 1 and 2. In Chapter 1, we explained the various features of a bond while in Chapter 2 we explained how those features affect the risk characteristics of a bond relative to bonds without that feature.

In this chapter, we look more closely at the differences in yields offered by bonds in different sectors of the bond market and within a sector of the bond market. This information is used by investors in assessing the “relative value” of individual securities within a bond sector, or among sectors of the bond market. Relative value analysis is a process of ranking ...