Spread ’em

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By Guest Blogger Scott Booth

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Words you don’t want to hear during interactions with law enforcement.

Spreads can mean different things depending on the subject matter.

When gambling, the spread evens the odds between two unevenly matched teams. Canadians watching sporting events on TV get reminded of this about 10 times an hour and invited to tack on a same game parlay thanks to the 2021 legalization of single-game sports betting and the advertising scourge that followed it.

In finance, the spread refers to the difference or gap that exists between two prices, rates, or yields.

Bonds trade on a spread basis.

Let’s say an investor wanted to buy a 5-year corporate bond. Speaking to a trader, they might get a bond offered to them at “150 back.” This means the bond can be purchased at a yield of 150 basis points (bps) (1.5%) above the Government of Canada 5-year benchmark bond. If said benchmark 5-year bond is trading with a yield to maturity of 3.5%, the corporate bond would be offered at a yield of 5.0% (3.5%+1.5%=5.0%). This 150 bps is the credit spread.

Credit spreads are influenced by a variety of factors, from company specific changes in the financial health, to broader fluctuations in economic conditions, business cycles, changes in liquidity and investor sentiment. Monitoring credit spreads in aggregate can offer some insights about the confluence of the various factors listed above.

Generally, narrowing spreads reflect positive sentiment and demand and conversely, widening spreads are negative.

What is the trend with credit spreads of late?

Investment grade credit spreads Feb 2023-now

Source: Bloomberg, Turner Investments.

Tighter. The premium that investors are demanding to take on corporate credit risk is diminishing. Fast. Spreads are narrowing aggressively as the market opines that things are getting better. Optimism is the theme here.

Globally, the average spread on corporate notes including investment-grade and junk debt securities is hovering around its lowest since the start of 2022. Despite the diminishing reward for taking on credit risk, appetite for corporate credit has seemed insatiable, with record supply gobbled up as investors hunt for yield with animal spirits spurred by expectations for rate cuts from central banks as we move through 2024. Risk-reward trade-offs aren’t what they were 4 or 5 months ago.

Almost US$232B in corporate bonds issued in 2024

Source: Bloomberg

For yield-seeking investors, the Canadian equity market seems a pretty good candidate at this point. Bank of America (BoA) recently highlighted this in one of their research reports, suggesting investors should “Own Canada.” As illustrated in the chart below, the S&P/TSX Composite Index dividend yield of 3.2% is just over two times the level offered by the S&P 500, a record spread, according to BofA. They suggest that the Canadian benchmark “offers a great entry point” at 15 times earnings per share. The multiple for the S&P 500, which has been advancing in large part led by Big Tech shares, is around 22.

Dividend yield S&P500 (white) vs S&P/TSX (blue)

Source: Bloomberg, Turner Investments.

Foreign exchange is another place where spreads matter. If you walk in and visit TNLATB to buy some US dollars before heading off on vacation, you’ll be paying a spread. Probably a hefty one.

I looked at some posted rates today (from the green guys with the comfy chairs) and they offer to sell you US$ for $1.3820 and buy the Big Dollar from you at $1.3083. That’s almost seven and a half cents of bid-ask spread. If you’re buying that probably means you’re paying about a 2.7% premium over the spot rate. If you’re moving a bunch of money between currencies, shop it around. For what it’s worth, Norbert’s Gambit can be a good tool for reducing FX conversion costs and minimizing spreads.

Spreads are an important consideration in the investing and personal finance world. The benefits of being aware of what they are, where they are embedded, and the direction they have been trending can help guide investment decisions and/or save you money.

Of immediate import, Americans are expected to wager $23 billion on the Super Bowl on Sunday. The San Francisco 49ers are 2.5 point favourites over Mr. Mahomes and Tay-Tay’s BF. I think they’ll cover the spread.

Go Niners.

Scott Booth, CFA, is a seasoned financial advisor and licensed portfolio manager. Over the past 18 years he has worked in the capital markets as an analyst, trader and advisor with major banks and now with Turner Investments.

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About the picture: “Meet Sitka! She’s a 9 year old rescue hailing from Calgary,” writes Mike. “Her folks are happy renters earning a healthy living, saving diligently and ignoring the noise. Sitka takes most of the credit for her folks situation because she’s cuddly, cool and collected, but also gives a nod to Garth and the crew for dropping truth bombs on his folks. She notes everything in their home (and the photo) is used, homemade or wisely purchased. living frugal doesn’t mean living without the finer things in life!”

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