What is it?
You’ve often heard of debt fund managers talking about “spread” and using it to their advantage in the debt markets at different points in time. A “spread” is the difference in the yields between two classes of debt instruments such as government securities (G-secs) and corporate bonds, or even within different instruments in the same class but those that carry different credit ratings, such as a AAA-rated bond and AA-rated bond. For instance, if a one-year G-sec’s yield is 8.74% and a government-owned firm’s bond of a similar tenor is 9.997%, then the difference or the “spread” between the two is 1.257%.
Why are they present?
Within the same class of instruments of a similar tenor, there is a difference of yields. The government of India carries the highest credit rating as lenders (investors who invest in debt securities) would rather prefer to lend money to the government than any private company. Hence, they typically carry lower coupon rates Further, between the government-owned and private sector companies, typically government-owned firms have a lower yield (and a lower coupon rate) because these firms are partly owned by the government and are, therefore, perceived to be relatively safer. Private sector companies come with credit risk and hence, to compensate the investors, they offer a higher coupon rate. So the “spread” is the largest between private firms and other categories in the debt market.
When interest rates fall, prices of debt securities rise. However, yields of debt securities across different classes may not fall in the same manner. Looking at the prevailing spreads though, you can get an indication of how yields across asset classes would move.
Benefiting from spreads…
Fund managers try and make use of spreads to make gains in their bond portfolios. A long-term bond fund, typically, allocates money across corporate bonds and G-secs. When liquidity in the banking system goes down, short-term interest rates go up. If the fund manager feels that the “spread” between the two is large (yields from corporate bonds are significantly higher than those offered by G-secs), he may invest a large chunk of his portfolio in corporate bonds. A higher-than-normal spread (typically 3 percentage points or more) would reduce once the liquidity situation improves. In this case, the interest rates for corporate debt scrips come down and their underlying prices—and therefore the net asset values of these debt funds—go up.
…can expose you to risk
It looks tempting—and perhaps easy—to benefit from spreads; invest in high-rated private sector company scrips and wait for interest rates to fall. However, your fund manager needs to correctly predict how interest rates would move. For instance, if interest rates rise, a spread doesn’t help as yields of private firms will also go up. Also, your fund manager should need to watch out for credit ratings of these companies. Lower-rated scrips carry higher yields—and offer better spreads—but they can be risky and illiquid.