A spread is the difference between the bid and ask price of an asset. To explore further, let`s take a take an example from the US debt market. For example, in 2011 AT&T issued a new 10-year bond at a rate of 4.45%. Since the yield on 10-year US Treasury at that period was 3.34%, the spread was 1.11% or 111 basis points. The difference in the US Treasury yield and the corporate bond is due to the perception of risk associated with the instrument. AT&T was a true blue-chip company, but even so it could not match the US Treasury in terms of risk. US Treasury notes are deemed risk free.
If I were to issue bonds, I`m quite certain the rate would be higher than 4.45% as market participants would view me as someone who is less reputable in terms of paying back my loan compared to AT&T.
How do we quantify spreads? If the holder of a corporate bond has a 20% probability of losing 10% of her money each year, the risk spread on that bond is 20% of 10%, or 2%.
Excessive spread can be detrimental to the economy and there are three main steps in terms of reducing wide spreads:
1) The government takes steps to reduce the perception of risk either in the overall economy or by holding specific securities. The former can be achieved by improving the macroeconomic picture while the latter via mitigating the foreclosure problem.
2) The government can guarantee debts so private investors do not bear the credit risk.
3) The government can buy up securities that are perceived as risky thus bringing up the price and yields down.
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