In the fixed income world investors often talk about “the spread” as one possible driver of returns. But what is “the spread” and why does it exist? Generally speaking, the spread in interest rates which is also called “credit spread” refers to the difference between two interest rates, often between a benchmark rate (normally the interest rate of government bonds) and a specific interest rate on another type of bond (such as corporate bonds). For example, if a 10-year government bond has a 3% interest rate and a corporate bond of similar duration has a 5% interest rate, the spread is 2 percentage points or 200 basis points (bps).Therefore, investors need to bear in mind that the interest rate of a bond includes the spread at the time when the bond was issued. As the spread can widen or narrow over time, these changes are represented in the price of the bond. This means that spreads can be used as an additional source of return when they are wide and expected to narrow or must be seen as a threat when they are (too) narrow and expected to widen. Since all investors know that a higher interest rate is a compensation for higher risk, one needs to analyze why the respective (corporate) bond pays out a higher interest rate compared to the benchmark bond to understand which risk(s) are driving the returns of a bond (portfolio).The main factors which impact interest rate spreads are:Credit Risk: Bonds issued by borrowers with a higher risk of default compared to the benchmark bond typically face higher interest rates than the benchmark bond(s). In most cases government bonds are used as benchmark bonds, as government bonds are seen as lower-risk bonds than corporate bonds, therefore the government pays a lower interest rate than a corporation or individual. The higher the difference in the credit quality, measured by the credit rating of the issuer, the wider the spread should become. This is because the spread is the compensation for the additional risk taken by the investor.The part of the spread caused by the credit risk can widen or narrow, depending on the economic situation of the company, its industry sector, or the economy as a whole. This means any change in the spread can have a positive or negative impact on the price of the respective bond within a portfolio, even when the general interest rates stay the same.Liquidity: As it is harder to buy or sell less liquid assets, bonds with an in general lower liquidity normally require a higher yield to attract investors, which as a result leads to a wider spread. As government bonds are usually more liquid than corporate bonds, corporate issuers need to pay a higher interest rate, even as they may have the same credit quality as the government. There are also spreads visible between bonds issued by different governments with the same credit quality. With regard to this, investors need to bear in mind that liquid bonds can become illiquid over time which may lead to a widening of the spread and a respective declining price for the bond itself.Market Conditions: The general economic and/or market conditions, such as supply and demand for credit, can cause spreads to widen or narrow. We often see that spreads are widening during phases of economic uncertainty, as investors often demand extra compensation for risk in such periods. Since the future capability of a corporation to pay back its debt is harder to evaluate than the capability of a government, corporations have to pay a higher interest rate for their bonds than governments, even as the corporate bonds might have the same maturity, liquidity, and credit rating as the benchmark bond.Maturity Differences: Spreads can also reflect different time horizons. Within normal market conditions, a bond which has a shorter maturity than the benchmark bond, should have a lower interest rate than the benchmark bond. If the maturity of a given bond is longer than the maturity of the benchmark bond, the interest rate should be higher. The reasons for this are the uncertainties about inflation, economic conditions, and other risks, such as the corporate risk, over time. Nevertheless, there are time periods with inverted yield curves during which short-term bonds have a higher yield compared to long-term bonds.To sum this up, it could be said that spreads are the compensation which investors demand for taking on risks such as credit risk, longer durations (maturity), or reduced liquidity at a given point in time. As spreads are not fixed, they can impact the results of a bond portfolio negatively or positively over time. This means investors can use the spread as a driver for returns when they expect the spread to narrow.That said, the overall risk caused by the respective bonds need to be inline with the overall risk bearing capacity of the investor. In addition, spreads are often used as indicators of the overall market confidence or risk tolerance. Even as this list of risks above might not be complete, it offers a sound understanding of why spreads exist and how they are impacting the returns of a bond portfolio.More By This Author:Q3 2024 U.S. Retail Scorecard – UpdateRubber Meets Road For Divergent Buyout-Shop Models S&P 500 Earnings Dashboard 24Q3 – Friday, Nov. 8