Alroy Commentary - Why investors always look at the Bond Spread during the European Debt Crisis?
In the European Debt Crisis over last few years, professional investors always talk about “Bond Price”, “Bond Yield” and “Yield Spread” of PIIGS countries. Do you really understand the meanings of these financial terms? And why are they so important?
The concept of “Bond Price” is straightforward. When the bond issue, issuer sell the bond by the face value. After issue, bond price can go up and down in the bond market, depends on the demand and supply.
In contrast, the concept of “Bond Yield” is more complicated. Unlike stock, most of the bonds have maturity dates, the date that borrowers repay the principal to bond holders, and distribute coupons, the interest rate stated on a bond when it's issued, to bond holders regularly. Because bond holders can get the face value of the bonds at maturity date, if someone is willing to sell the bond at discount and the new investor hold the bond to the maturity date, he / she can get a higher return. The percentage return of the holding bond is “Bond Yield”. When bond price drops, bond yield increases, vice versa.
The difference of yields between bonds or debt instructions is “Bond spread”.
Normally, investors ask for higher interest rate or “Bond Yield” for lower quality bonds as they involve higher default risk, the risk the issuers do not repay the principal or do not repay on time. During the European Debt Crisis, investors believe Greece is very likely to default, so investors sold her bonds in the market and the bond yield of Greek bond surged to sky high. Investors pumped their money to German Bund as the economics of Germany was healthy. The price of German Bund increased and its bond yield dropped to the historical low. That is the reason the yield spread between European peripheral countries’ bonds and German bonds (benchmark bond) was widening throughout the European debt crisis as investors were losing confidence to PIIGS countries. Investors use “Bond Spread” between European countries to measure the sentiment of investors.
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