Thanks to the ongoing financial crisis in Europe, the phrase “Italian spread” has come to signify much more than a bruschetta lightly glazed with extra-virgin olive oil. With sovereign bond yields reaching over 7%, the Italian government is facing a potentially crippling liquidity crisis as it faces the prohibitive costs of obtaining financing to meet its spending obligations. Yield spreads are now everybody’s business, it would appear.

In this post, we look at yield spreads, why they should matter to you, and how to apply knowledge of spreads to your investment decision making process.

Absolute and relative measures

In evaluating interest rates, we apply both absolute and relative measures. The phrase “yields on Italian sovereign bonds are over 7%” is an absolute measure – it means that the Italian government pays seven euros for every hundred euros it borrows from creditors. “The Italian spread to bunds is 5.3%” is a relative measure of the costliness of Italian bonds versus German government bonds. Bunds are the German equivalent of US Treasury securities. There is no magic to the calculation – yield spreads are a direct function of supply and demand. Spreads to riskier assets tend to widen in times of economic uncertainty as investors seek the relative safety of those investments least likely to default – like German bunds – and abandon those whose financial circumstances appear shaky.

In many ways, yield spreads are a more informative measure of what’s really going on in credit markets at any one time. They tell you how the market views the creditworthiness of any one instrument versus another. In another time and place, a 7% yield on Italian bonds may not have been particularly noteworthy – there have been times in the past when the cost of credit in general (for worthy borrowers included) was much higher than it is today. But the fact of being considered by the market to be more than three times riskier than another Euro-denominated security tells you that Italy – along with other Eurozone nations with high spreads relative to the German benchmark – is in serious financial trouble.

Yield spreads in our daily lives

Yield spreads have an even more direct impact on our lives than the value of fixed income investments in our portfolio. In the US, we benchmark just about all financial instruments from corporate bonds to mortgages and unsecured personal loans to US Treasury securities. All else being equal, when the cost of borrowing for the US government falls, the cost of our personal credit decisions should fall as well. But all else is rarely equal. Consider the chart below, showing the trend of US mortgage rates compared to that of the 5-year Treasury note.

What stands out about this chart is how spreads between consumer credit and benchmark yields vary dramatically over time. In early 2011, yields on US government bonds rose considerably, while consumer credit rates stayed flat or even came down a little – in other words spreads narrowed (good news for individual borrowers). More recently, that trend has reversed and while benchmark yields have fallen dramatically from their spring highs, mortgage rates have barely budged. This matters for both borrowers and for policymakers. If policy-directed lower interest rates do not translate into easier credit conditions in the economy, then the policy’s objectives of higher growth and lower unemployment are less likely to ensue.

Yield spreads and investment decisions

How do you incorporate yield spread trends into investment decisions? Here, you have to take a number of factors into account. For example, if you think that worries about Italy are overblown, that it is too big to fail and will eventually be helped out of its woes by its Eurozone partners, then it may make sense to lock in that extra 5.3% in yield you get relative to parsimonious German bonds. After all an annual yield of 7% looks pretty fetching in today’s returns-challenged environment. On the other hand, market experts, like Bill Gross, are advising investors to stay away from this particularly messy “food fight” on the continent.

Ultimately, these decisions come down to judgment. One bond’s spread is higher than another because the market assesses its potential to default – to be unable to make full and timely payments on its interest and principal – as higher than the other. Italian spreads probably don’t have much room for further increases before they hit the point of no return – so buyer beware

Tell Us

Do you think a 7% yield on Italian bonds is an opportunity to lock in a desirable return…or do you see it as too risky to pursue?

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