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Yield Spreads

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Yield spreads represent the added income an investor can receive by taking on more credit risk. The U. S. Treasury Note is considered to be the risk free rate for any given maturity. To induce an investor to buy a riskier corporate bond, the borrower must pay a higher rate of interest than the Treasury. A single A-rated corporate borrower would have to pay a higher rate than a AAA-rated borrower, and a BB-rated borrower higher still.

This differential, however, is not static. As investors become more concerned about the economic outlook, they become more risk averse and the markets experience a “flight to quality”. At times like year-end 2008 in the midst of the financial crisis, fear and skepticism were so rampant in the bond market that few would even look at lower rated bonds and the yield spreads became very large. The chart below shows the difference in yield between indexes of US Treasuries and investment grade corporate bonds. The differential reached a high of approximately 6.5 percentage points in November of 2008. As financial collapse fears have receded, the spread has narrowed to 2.75 points.

We are willing to take on incremental risk to earn higher returns, but only when we deem the income compensation makes it worth our while. Going forward our emphasis will be on upgrading the quality of your bond portfolio since these spreads are narrowing.

Yield Spread - ML Corp Master Yield minus ML Treas Master Yield