Saturday, April 4, 2009

Bond Yields - The "Yield Spread"

Let's enjoy a difficult practice question on a Saturday, shall we?

One of your customers, Joe Myers, calls to inquire about something he heard but did not quite understand on CNBC. "Why is the price differential between low-risk and high-risk debt securities smaller than usual?" he asks. You would respond
A. turn off the TV and get a life, Joe
B. it means investors are confident in the overall economy
C. it means investors are not insisting on safety to the same degree
D. both B and C

EXPLANATION: right now, investors will accept tiny yields on Tbills, Tnotes, and Tbonds and won't touch junk bonds (corporate and muni) unless the bonds offer ridiculously high rates. The "yield spread" has widened in other words because investors are freaking out. For a few days, investors dumped everything and ran to Treasuries, accepting NEGATIVE yields on Tbills. Seriously--people were giving Uncle Sam $1,005 in order to receive $1,000 in 3 months, essentially, which is known in financial textbooks as "really stupid."
Now, if the difference in yields between ultrasafe Treasuries and junk bonds narrows, that expresses confidence. Investors aren't so worried about companies defaulting on them and will pay more for the bonds/accept lower yields.

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