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Yield spreads offer treasury managers a critical tool for making effective investment decisions. Historical spreads gauge the relative attractiveness of investment alternatives and indicate the market consensus on near-term prospects for individual issuers and the economy. Most importantly, the keys to increasing portfolio returns can be found in the shifting market yield relationships.
A yield spread is simply the difference between two yields. Typically, one is an instrument of interest and the other a benchmark or reference point chosen for the certainty of its quality. The most popular benchmarks are risk-free rates (U.S. Treasuries), international base rates (LIBOR, Euro time deposits), domestic rates (for comparing to foreign yields) or quality tier rates (Aaa, Aa, A).
By far the most common benchmarks are risk-free rates. For example, on June 21, 1991, the three-month Treasury bill yield at discount (benchmark yield) was 5.55%, compared to the three-month discount commercial paper rate of 5.90%--a spread of 0.35% or 35 basis points.
The 35 basis-point spread quantifies the market consensus of the appropriate reward for assuming the greater risk--in this case, the risk of owning short-term unsecured corporate IOUs instead of riskless U.S. government obligations. Technical considerations also cause spreads to widen or narrow as market conditions change.
Spread relationships sometimes are expressed as ratios, calculating the yield of an instrument of interest as a percentage of the benchmark yield. Ratios can be more revealing than absolute basis-point spreads by showing changing risk/reward relationships when markedly different yield levels are involved.
For example, a 50 basis-point spread in a 4% market is more significant than a 50 basis-point spread in a 14% market. In the first case, it's a 12.5% premium; in the second, only a 3.6% premium. Basis-point spreads alone do not reflect the complete risk/reward relationship. Other things being equal, lower general interest rates should bring smaller spreads but relatively consistent ratios. The inverse also is true.
Investors who purchase both taxable and tax-exempt securities …