Yield Spreads: Why Traders Should Care

10/04/2011 1:30 pm EST

Focus: STOCKS

Jackie Ann Patterson

Author, Truth About ETF Rotation

Most short-term traders don’t monitor yield spreads unless they’re trading bonds, but Jackie Ann Patterson explains why it’s important for stock traders to pay close attention as well.

Yield spreads are a term that you heard in the past, but how as a trader should we use that information?  Our guest today is Jackie Ann Patterson to talk about that. So Jackie, first of all, what is a yield spread?

Well, a yield spread is the difference between the yields of different instruments. For example, the ones that I look at the most are the yields on Treasury bonds versus the yields on corporate bonds.

I’ve gotten interested in this not only from the perspective of looking at bonds and wanting to own bonds, but I think it’s also important as a stock trader, and it’s important to understand what’s going on with yield spreads to understand how that may impact the stock market.

How do they typically impact the stock market?

Well, typically, there’s a given spread between the Treasury and the corporate bonds, and as people decide that they need more payback for their money, they’ll buy more of the corporate bonds—maybe take more risk—and that will drive the yield of the corporate bonds down, and that will actually narrow the spread between the Treasury and the corporate bonds. 

That’s a sign of complacency in the market and that people are comfortable and that they want to earn more money and they’re willing to take some risk to do it. 

Then there’s the other side of the coin, and that is when the people get worried about the market, and particularly, large traders may start selling the corporate bonds and buying the Treasury, and maybe more important, buying the Treasury bonds. 

As that happens, then you’ll see the spread in the yields between the two of them grow wider apart. That can be an indication that traders, and particularly big traders, are getting serious about getting out of the market, and you can often look at that and see the beginnings of a flight to safety. 

Where do I find this information?

Well, there are a couple of different places to look at it. You can find it on your own charts really by bringing up ETFs of different bonds. You can look at the ETF of the Treasury and compare that to ETFs of corporate bonds. That’s what I do. I plot that on my chart and I have a look at it every week and try and keep tabs on what’s going on out there.

Does it give you a bit of a leading indicator how much time when I start to see these spreads widening or tightening do I get our or get in?

I think it’s kind of imprecise, but it’s also kind of a big signal. It’s something that once you see it definitely change character, then the market may still go up a little bit, but it probably won’t be worth it to stick around.

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