Interest Rate Spread – Chart of the Week

 

Today’s “Chart of the Week” post on our Facebook page was out of a new report by the Richmond Federal Reserve. The chart consists of various interest rates since 2009, and I thought that it could use a little extra explanation on just what makes this so interesting to the finance world.

 

interest rate spread - federal reserve chart

 

The chart shows the differences (or spread) in various interest rates. Different maturities of mortgages, corporate bonds and U.S. Treasury bonds are the typical categories compared.

 

What makes this chart so special?

 

Interest rates can tell investors a lot about the economy and expectations for the future. In the chart above, compare the difference in the dark blue line (10 year Treasury yields) to the teal line (Corporate BBB rated bond yields). Notice in 2009, during the depths of the recession that companies looking to borrow money were paying 7.75% – 9.5% interest depending on credit rating, while the U.S. government was paying only about 2.75%.

(The AAA and BBB represent the credit ratings of the businesses. Think of it like a credit score for the business. AAA is best, BBB a little worse but still decent, CCC and below is considered “junk”)

 

This difference between that corporate bond yield and U.S. Treasury yield is also known as the “spread” between corporate interest rates and U.S. Government interest rates. At the peak in 2009, the spread for BBB rated companies was around 8.75%. In other words, those companies had to borrow at a rate 8.75% HIGHER than the U.S. Government.

 

Generally the U.S. government is used as a comparison because U.S. Treasuries are considered the “risk free” investment. Unlike corporations, the U.S. Government cannot run out of money as it has the power to create more. Inflation may be a factor, but the U.S. is always able to repay its debt obligations.

 

Now compare the spread between BBB rated corporate bonds to U.S. Treasuries in 2009 to that of 2014. As of this writing, that spread is less than 1.5%. So why the change?

 

Higher Interest Rate Spread Signals Higher Risk

 

In the recession of 2008/2009, investors were worried that just about every company was about to fail. The ability for companies to borrow from banks had seized up, and investors’ fear of bankruptcy showed up in a higher interest rate spread.

Compare that to 2014, where investors are beginning to believe in the U.S. economy once again, and companies have much stronger balance sheets after de-leveraging during the recession.

 

Similar comparisons can be made using the chart above for AAA rated corporations, which as of this writing can borrow at nearly the exact interest rate as the U.S. Government, but had a 5+% spread in the midst of the recession.

Spreads amongst corporate bonds, and even household mortgages to the U.S. Treasury rate can help investors identify general market sentiment and expectations of the future (and therefore find investment opportunities created by market euphoria or pessimism). For example, a large spread as we saw in 2009 identified investor’s fear and doubt of corporations being able to weather the storm. Investors willing to invest in corporate bonds on average saw a very good return.

Today interest rates in AAA rated companies imply that investors believe there is 0 risk in those bonds. An obvious sign of over exuberance.

 

Spreads in Duration Also Play a Key Role

 

But there is much more to look at than the spread between corporate interest rates and U.S. Treasury rates.

 

Often investors look at the differences in interest rates at different maturities, or durations of bonds as well. Consider the front page news story on Reuters just a couple days ago:

in_the_news

 

Here, they are noting the spread between the 5 year U.S. Treasury note and the 30 year Treasury bond.

 

What’s the difference between a bill, note and bond? See our post here.

 

This spread between different maturities tells investors about expectations in future interest rates, inflation and more.

 

By creating a chart of the interest rates at different durations, you develop a chart that looks like this:

48TSYELD

Or a “Yield Curve”, with the slope of the curve signifying the spread in interest rates. This is courtesy of the Wall Street Journal.

 

This interest rate spread, or yield curve, is updated every day in the Wall Street Journal paper. What does this tell investors?

Short term interest rates gauge current investor sentiment. In the midst of the 2009 recession, short term interest rates actually went NEGATIVE, meaning investors gladly gave away money just to be certain that was all they lost. This just goes to show the level of fear at that time.

 

Long term interest rates tend to display investors future inflation and growth expectations. Investors purchasing, for example, 10 year treasury bonds are committing capital for 10 years, if they expect inflation to increase, they will demand a higher interest rate to compensate.

 

The spread between these short and long term rates, and how that spread changes over time clues investors in on growth expectations, inflation expectations and more.

Imagine a “flat” yield curve, where a short term bond yields for example, 3% and a long term bond also yield 3%. What does this tell us? Investors are expecting no growth, and no increase in inflation.

 

 

In Conclusion

 

So why is this worthy of the chart of the week? Besides being interesting to see long term trends play out (for you financial nerds like me), it does give us a ‘tell’ on investor sentiment.

 

Today, the “panic for yield” has brought down corporate borrow rates tremendously. As this chart shows, investors are getting absolutely no added return for the risks in their investments in AAA corporate bonds, and very little in BBB rated bonds and below.

Interest rates are a great tell of market sentiment and today imply some over exuberance in bond investors. It will be fun to watch this play out.

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