Like equity markets, the bond market has its own jargon that can be confusing, with terms like ‘Yield Curve’ and ‘Credit Spreads’. So what does it all mean?

Yield Curve. A ‘yield curve’ is a line that plots the yields (ie. the interest earned) for bonds with the same credit quality, but different maturity dates. The Australian Government Bond yield curve is commonly used as a baseline for other markets, because the assumption is that it carries little risk of default and has regular maturity points.

Credit Spreads. ‘Credit spreads’ are an indication of the additional interest or return investors demand for lending money to a corporate rather than the government, because the former are more likely not to repay the amount borrowed (ie. default). Rather than describing yields on corporate bonds in absolute terms, it’s common to refer to differences in yields, or the ‘spread’ between different types of bonds. For example, if a 3 year government bond yields 2.5% and a 3 year BBB-rated corporate bond yields 4.5%, the corporate bond is said to be trading at a 2% spread compared to the government bond.

References to changes in credit spreads (eg. credit spreads have narrowed or widened) is a relative term that gives no clue as to what has happened to a bond’s absolute yield and hence price. It simply tells you whether the corporate bond has outperformed or underperformed, compared to its nearest benchmark government bond. If the yields on both corporate and government bonds fall, then both prices will have increased (given the inverse relationship between yield and price). But the government bond will have outperformed the corporate bond, if the spread between them widened, and vice-versa if the spread narrowed.

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Source: Yield Curves, Credit & Credit Spreads by Australian Corporate Bond Company.