Expert: Doug Ingram - 10/27/2011

Question
Could you explain what is meant by the following sentence?

"Italian bonds spread decrease by 22 bps to 475 bps"

I know that a spread is the difference between one thing and another thing (for instance the spread between light sweet crude and Brent is about $20) but do not understand what the spread in bonds is comparing with. Also which is better a higher spread or a lower spread?

Answer
The spread is usually the difference in yield between the safest rate and the bond you are buying.

If a 10-year Treasury (usually assumed to be the safest rate) is yielding 2.25%, an investor would want 7% to take the risk of owning an Italian bond.  Investors want to be rewarded for taking risk.
(475 basis points [bps] ...  700-225=475)

Tighter spreads are closing in - so the Italian bond was yielding 7.22%, but the market thinks the European Central Bank and finance ministers in Europe are coming up with solutions.
Thus, maybe a little less risk...

If it appears the Euro situation is worsening, spreads might widen.  You are offered more yield to take the risk.
They also float to each other.
If the U.S. 10-year goes to 2.50%, the Italian bond would go to 7.25% (2.5% plus 475 bps).

If the U.S. goes to 2.50% and Europe is more unsure - causing spreads to widen 50 bps, the yield would go to 7.75% (2.50% + 4.75% + .50%)

Higher yields are better, but only if they pay.  The higher the yield, the more risk of default.

Also, the higher the yield the lower the price.
If you buy the Italian bond and the yield goes up because spreads widen, your bond goes down in value. (because you could have bought a higher yield)