The Spread: What It Is and Why It Is so Important

Have you ever wondered what the term spread actually means? It’s a word we often hear on the news, particularly in relation to European economies. Let’s break down the concept of the spread and why it’s so important in finance.

What Is a Financial Spread?

The word “spread” itself can have many meanings, but in finance and economics, its primary meaning is a “difference” or “differential”.

A financial spread is the difference between the prices, yields, or interest rates of two similar financial instruments offered by different entities. This difference is often used to assess the perceived risk associated with the instruments or the entities that issued them. In essence, it reflects the level of confidence in a borrower’s ability to repay their debt with interest.

A typical example is the bid-ask spread, which is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept for a financial instrument.

Understanding European Bond Spreads

The spread most frequently discussed in the media is the one that indicates the difference between two government bonds.

A government bond is a type of debt security or an official promise by a country to repay a loan with interest. Governments issue these bonds when they need to raise money. The yield on a bond is the return an investor gets, which is determined by its price on the market and the interest paid.

Like all bonds, government bonds can be freely traded on the secondary market before they mature. Financial operators, including banks, investment funds, and private citizens, can buy or sell these bonds at market prices. A bond’s price is determined by supply and demand.

Globally, government bond spreads are generally referenced against the German Bund or the US Treasury Note. In the European context, the term “spread” is commonly associated with the differential between the yields of sovereign debt securities of Eurozone countries and the German Bund, which is considered a benchmark for the Eurozone. This spread reflects the risk premium associated with a particular country’s debt securities compared to those of Germany, which is regarded as a more stable and secure economy.

Because this risk is associated with a state and not just any instrument, this value also indicates the reliability and political strength of a government. This is especially relevant in the context of the European Union, whose integrity requires a minimum level of coherence among its members.

Italian spread: BTP-Bund

The bonds sold by the Italian state have various names, including BOT, BTP, CCT, and CTZ. The meaning of these acronyms is respectively Buoni Ordinari del Tesoro (Ordinary Treasury Bills), Certificati di Credito del Tesoro (Treasury Credit Certificates), Buoni del Tesoro Poliennali (Multiannual Treasury Bills), and Certificati del Tesoro Zero coupon (Zero Coupon Treasury Certificates). However, their name does not have a significant impact on the BTP-Bund spread, which is the one that concerns Italy.

The most crucial difference between these bonds is their maturity. A BOT matures within 3, 6, or 12 months (a maximum of one year) from subscription; a BTP has maturities of 18 months or 3, 5, 7, 10, 15, 20, 30, and 50 years. The longer the maturity, the higher the yield. But which maturity is considered when calculating the spread between two countries’ debt? By convention, the 10-year maturity. In Italy’s case, this refers to a BTP.

In Italy, everyone started wondering what the spread was and what it meant, especially in 2011, when it reached record levels. This was the year the European sovereign debt crisis erupted, which directly involved Italy as a debtor nation. In that situation, investors sold Italian bonds, which were deemed risky, to buy Bunds instead, leading to increases in Italian yields and decreases in German ones. The market feared that the government would be unable to repay its BTP debt. This caused a surge in the spread, which reached a historic high of 5.5% in November.

How to Calculate the Spread

The spread is a numerical value that can be easily calculated using the following formula:

Spread = Yield of Subject Bond – Yield of Benchmark Bond

For example, if the yield on a 10-year Italian BTP is 3% and the yield on the German Bund is 1%, the BTP-Bund spread would be 2%. This 2% represents the risk premium associated with the Italian bond compared to the German Bund.

Spreads are often expressed in basis points (bp), where one basis point equals one-hundredth of a percentage point (0.01%). So, a spread of 1.65% is the same as 165 basis points.

It’s important to know that a spread can widen even if a country’s bond yield remains stable. This can happen if the benchmark bond’s yield decreases, making it seem safer and thus increasing the differential between the two.

What a High Spread Means

An increase in the spread indicates that the yield demanded by investors has grown relative to the benchmark. For example, if the Italian bond yield rises compared to the German one, it means that Italy is perceived as a riskier investment.

A nation with low market confidence must offer higher returns on its government bonds to attract investors. This results in higher borrowing costs and an increase in the overall public debt.

Changes in the spread are not always tied to an actual increase in the absolute value of a country’s bond yields. A spread can also widen if one bond’s yield remains stable while the other’s decreases. This scenario may reflect a change in the perception of risk. For example, if the yield on a 10-year Italian BTP remains at 2.55% while the German Bund’s yield decreases from 0.90% to 0.70%, the spread would widen from 165 to 185 basis points. In this case, the perceived risk of Italian debt remains the same, but the German Bund is considered safer.

What a high spread means for governments is clear, but what does it mean for citizens and businesses?

Understanding the spread is crucial for making sense of the financial world, but it’s just one piece of the economic puzzle. By knowing what it is and what its movements signify, you can better understand economic news and how it affects both governments and ordinary citizens.