In booming markets, investors easily overlook investment fundamentals. Market corrections have a way of painfully reminding investors that those fundamental market principles are still relevant, and this market is no different. One of those principles is the historical relationship of different assets or investment characteristics to one another, which reflect the cumulative results of many years of economic and investment experience. And one of the relationships which clearly reflect market sentiment is the difference between the yields on various fixed income investments, commonly referred to as “spreads”.

Before any discussion of spreads, it is helpful to review some of the basics of investing in fixed income securities, or bonds.

A bond is any interest-bearing security that obligates the issuer (the borrower) to pay the bondholder (the lender, or investor) a specified sum of money, usually at specific intervals, and to repay the principal amount of the loan (or bond) on the maturity date.

All interest rates are not created equal (for purposes of this discussion, “interest rates” and “yields” will be used interchangeably). The Federal Reserve sets a target rate for overnight lending between banks, and changes in this target rate are reflected in areas such as prime lending rates, short-term certificates of deposit, bank accounts and money market funds. This target rate was recently set at a range of 0.25% to zero, an all-time low.

All other rates (longer-term Treasury securities, corporate and mortgage bonds, etc.) are determined by the supply and demand of the market, and especially by investors’ perception of risk. The primary elements of risk are quality (the likelihood that the issuer may not be able to make either the ongoing interest payments or the principal repayment) and time. The longer the maturity of the bond, the higher the rate, as investors accept greater uncertainty of future economic changes, returns in competing investments and their own needs and circumstances and so demand a greater yield for committing their money.

There is an inverse relationship between yields and prices in the fixed income world. If the yield demanded by investors on a particular type of bond goes up, the price of that bond goes down. Likewise, if the yield goes down, then prices will go up.

A closely watched relationship is the yields of US Treasury securities of various maturities, commonly referred to as the “yield curve”. The yield curve begins with three-month Treasury bills and ends with 30-year Treasury bonds, and the shape of the curve, or the differences in the rates, can give an indication of expected economic growth. The “normal” curve rises fairly steeply but then slopes more gradually, with a difference of around 3% between yields of the short and long maturities. (The yield curve is currently close to normal, albeit at very low yields across the curve, and may be more an indication of the uncertainty of future growth rather than the usual sign of steady growth in the middle of an economic expansion.)

When the difference between short and long yields is noticeably greater than 3%, the yield curve is said to be “steep”. A steep curve is usually at the beginning of an expansion, or when rapid expansion is expected, and long-term investors are concerned about being locked in to low yields. The yield curve can also be “flat”, or show little difference between short and long term yields, usually indicating an economic slowdown or lower future rates across the board. A flat curve also occurs on the way to an “inverted” curve, where short term rates are actually higher than long term. This transitional situation is a strong signal of a coming slowdown, and long-term investors are willing to accept a lower yield now before rates tumble in the future.

The other spreads are the difference between the yields of other types of fixed income instruments and the 10-year Treasury yield, known as the “benchmark” Treasury. During 2006 and 2007, these spreads became very narrow as high demand for mortgage-backed and other exotic securities caused investors to overlook the risks. In the fourth quarter of 2008, as credit markets seized up and there was real concern that the entire financial system might fail, the spreads for mortgage-backed securities and high-yield bonds soared to record high levels. These spreads were further driven by the realization that the risk of these securities had been poorly assessed, and on the other side of the spread, the benchmark Treasury was driven to extremely low yields as investors “fled to safety” and their buying drove prices up and yields down.

Why do spreads matter? Simply put, when spreads diverge from their historical norms, either by growing wider or narrower, they will eventually return to that historical level. For example, if spreads are wider than normal, one way for the spread to return to normal is for the yield on the higher-yielding bond to come down, resulting in a higher price. Evaluating spreads, and making judgments as to how and when those spreads will change, is essentially how fixed income professionals manage portfolios. By identifying and capitalizing on anomalies in spreads, they hope to outperform the overall fixed income market.

The trick is that either side of the spread can move to restore the norm. In the example of a wide spread, it may turn out that the yield on the lower-yielding bond will increase, leading to a price decline. So, while spreads can be excellent indicators of market sentiment and can identify potential opportunities, they still require an investor to make a thorough risk assessment based on his own needs and circumstances.