Treasury yields are the base rates used in comparing other bonds, particularly corporate bonds, and other asset classes such as stocks, commodities, and foreign currencies. Because Treasury rates are of the best quality available and represent a wide range of investment maturities from 3 months to 30 years, traders and investors are able to compare the relative risk of investing in higher yielding, riskier credit situations.
Creating the Spread Curve
A spread curve is created by establishing two yield curves, one for corporate bonds and one for Treasury bonds. Yield curves are built by taking the yield to maturity of all important trading maturities outstanding such as the 3 and 6 month, 1, 2, 5 and 10 year intermediate maturity, and the long term 20 and 30 year maturity. These yields are connected and graphed. The same process follows for the corporate bond under study. The difference in yields is measured by subtracting from the two curves. The difference is the spread of the yield curve. The shape of the three yield curves may be positive, indicating positive economic growth or flat, considered a sign of stagnating economies, or negative, indicating recession.
Quoting Corporate Bond Spreads
Corporate bond trades are quoted by the difference between the U.S. Treasury bond and the corporate bond under consideration. This is for convenience as bond prices change by small amounts every moment. Thus, with the government bond at 5 percent, a corporate bond currently trading at 6 percent would be quoted at "plus 100" or 100 basis points more than the Treasury bond. A basis point is one-hundredth of a percent.
Corporate Credit Spread Relationships
Credit review agencies have established many levels of credit quality. With each successive lowering of credit quality the spread relationship will widen. Generally, when the economy is strong and cash flow is rising for many issues the relative credit spreads between corporate bonds and government bonds will narrow. During recessions, even while interest rates fall from the decline in economic activity, relative spreads will widen as investors prefer credit strength under uncertain market conditions..
Factors Affecting Credit Spreads
Besides credit quality and maturity, a variety of other factors influence the relationship between corporate bond spreads and government securities. Many corporate bond issues are securities that are revenue specific. Cash flow from a specific division, a particular project, or a particular office where the company is domiciled may constitute the corporate credit of the bond. This means the general corporate cash flow and assets of the entire company are not available to the bondholder, only the revenues described in the bond agreement between issuer and borrower. Thus, a single company may have several spread relationships to a Treasury security even though the parent company is the same.