What Are Bond Yield Spreads and How Do FX Traders Use Them

What Are Bond Yield Spreads and How Do FX Traders Use Them

Reading time: 10 minutes

Changes in interest rates are one of the most dominant drivers of exchange rates.

Understanding bond yields requires a basic appreciation of a bond’s framework. Unlike equities, which provide ownership rights, bonds are debt securities designed to raise funds for the issuing entity (the borrower) and provide income for the bondholder or lender. 

A bond is commonly described as an ‘IOU’ between the issuer and the investor. Issued by companies or governments, when an investor purchases a bond, they are creditors, providing a loan that the issuer is contractually obligated to pay back, as well as periodic interest rate payments (the coupon rate) over the term of the bond to compensate the lender, such as 1 year, 10 years or even 30 years. The initial amount on the loan is referred to as the ‘principal’ and should be paid back once the loan term has reached the bond’s maturity date. This initial value may be the same as the ‘par value’ or ‘face value’ (a fixed amount used to determine the bond’s interest rate); importantly, a bond can trade at a premium to par or at a discount to par. For example, US Treasury bills, which have a maturity of less than 1 year, do not usually pay interest; instead, they trade at a discount to par, and the rate of return is the difference between the par value and the discounted price.

Unlike par value, a bond's ‘market value’ can change if sold in the secondary market before the maturity date.

Inverse Correlation Between Bonds and Yields

Bonds and their yield are inversely correlated, meaning that as a bond’s value rises, the yield falls, and vice versa. This relationship exists because investors continually seek higher yields on their investments. As a basic example, suppose you purchase a bond from company XYZ carrying a 5% coupon rate at its par value of $1,000. Imagine that a year later, that same company raises its coupon rate to 7%. This makes your bond at 5% unattractive. Therefore, to sell your bond on the secondary market, the price would have to discount its value (lower price) to generate 7%.

Government bonds are considered among the safest investment vehicles, backed by the full faith and credit of the issuing government; hence, they are sometimes referred to as ‘risk-free investments’. Given the additional risk of holding corporate bonds, they tend to offer higher yields to attract investors.

What Influences Bond Yields?

Increased economic activity (real GDP growth), inflation, job growth (and low unemployment), and consumer confidence drive changes in interest rates.

Other factors driving bond yields are central bank decisions and the anticipation of short-term interest rate changes – for example, if a central bank signals it will be cutting rates by more than expected, bond yields related to that country should see a depreciation versus other currencies – and, of course, yield differentials.

Bond Yield Spreads 

As a Forex trader, it is crucial to understand the meaning of bond yield spreads or ‘yield differentials’; the two are used interchangeably. A yield differential is nothing more than the difference between two bond yields; however, it can be a good indicator of the health of a country’s economy and, of course, the relative attractiveness between the two country’s bond yields.

One of the most widely followed yield spreads for Forex traders is the spread between government bond yields of the same maturity in two countries, which is what this article focusses on. Another commonly followed yield differential is the spread between a country’s government bonds of various maturities (for example, the 2 and 10-year US Treasury spread is widely used as a leading indicator of a recession).

At the core of things, as a bond yield spread between two countries widens, meaning one country’s yield is higher than another, this tends to see the country’s currency whose yield is higher appreciate (meaning there is a strong positive correlation between the two variables: the currency pair and the bond yield spread related to that currency pair). In addition, the spread between a bond’s yield can serve as a meaningful leading indicator, and that is its primary use for those who trade Forex. An example of the yield differential between the 10-year yield on government bonds between New Zealand and the US is shown below:

Chart Created Using TradingView

An important point is that absolute values are not as vital as the relative change in interest rates. It is all about how one country’s yield moves relative to another. Let’s take a basic example of the interest rate in New Zealand (the Official Cash Rate), which is at 5.50% at the time of writing, and the interest rate in Japan is at 0.00%. The absolute value is more attractive for the New Zealand dollar (NZD).

However, as Forex traders, the focus is on relative change. For example, if the spread for the yield differential between government bonds for New Zealand and the US is rising, this means the yield for New Zealand is increasing relative to the US, which could benefit the NZD. If the New Zealand yield drops – let’s imagine that New Zealand’s central bank turns dovish and there is an expectation of an impending rate cut as bond traders purchase bonds at current levels in anticipation of a drop in rates – and the US yield remains stable, the spread between the two yields will begin to narrow, and the line depicting the spread will turn lower. Thus, the relative attractiveness of the US bond will increase in this case, which could send the NZD lower versus the US dollar. Likewise, if the yield on the US bond rises more than the yield for New Zealand, the differential will narrow, and the line will start turning lower. Importantly, although yields are a key driver of Forex pairs, many factors can impact currency values.

Some of the most popular bond yield maturities Forex traders watch are the 10-year yield and the 2-year yield.

Longer-dated debt 10-year yield is often viewed as a proxy for consumer confidence and longer-term borrowing and is used as a benchmark for the risk-free rate. With the 10-year yield, bond traders are factoring in aspects such as policy, economic growth and inflation for the next 10 years. Improving economic conditions, for example, generally triggers a rise in riskier markets, such as equities, which can offer better returns on investment. In this case, bond traders tend to sell bonds (causing a rise in yields) in favour of equities. Conversely, an economic downturn tends to see bond traders seek safer investments, like bonds, causing a drop in yields.  

Shorter-dated debt, such as the 2-year yield, is primarily driven by market expectations surrounding the central bank’s benchmark rate. The 2-year yield is considered a better gauge as it is far enough into the future to account for slightly longer-term rate expectations, though close enough to reflect actual changes. For instance, if the 2-year yield is rising for US government bonds, and bond traders anticipate that the US Federal Reserve (Fed) will begin loosening policy, they may purchase bonds to lock in the more attractive current yields. Thus, this buying weighs on yields and signals the expectation of a lower Fed funds rate. On the other hand, if markets expect the Fed to begin tightening policy, bond traders may look to sell current bonds in favour of the anticipated higher yields (thus increasing bond yields).

Although not widely used by Forex traders, another popular yield spread is credit spreads – the difference between government bond yields and corporate bond yields (therefore, different credit ratings) of the same maturity. In simple terms, a credit spread reflects how much more yield an investor requires to assume the additional credit risk with corporate bonds over government bonds, the latter of which are generally considered risk-free investments.

How Do I Access Yield Spreads?

With FP Markets, if you have a live cTrader account, you can access TradingView and create your own bond yield spreads.

As an example, suppose you want to view the difference between the 10-year yield for New Zealand and the 10-year yield for the US, first open the NZD/USD H1 chart (you can open the chart in any timeframe; the bond yield spread will be the same), as below:

Following this, click on the + symbol located in the upper left corner, as demonstrated in the chart below:

In the Search function, type NZ10Y-US10Y, as depicted below, and simply press Enter.

You will then see the yield differential between the 10-year yield of New Zealand and the 10-year yield of the US applied over the price chart. If the yield spread is unaligned with the chart, click on the + symbol once more and ensure that the yield differential is set to a new price scale.

FAQs:

1. What is a bond?

A bond is a debt instrument corporations and governments employ to raise funds. Investors purchase these bonds as investments, providing a fixed income.

2. What is a bond yield spread?

A bond yield spread is the difference in yield between two different bonds. For example, the bond yield difference between the 2-year yield on the US government bond and the 2-year yield for Japanese bonds.

3. How can I access bond yield spreads?

If you have a live account with FP Markets and trade using cTrader, you can access bond yield spreads through TradingView.