What Is the Interest Rate Spread?

Identification

A spread is a measure of the difference between two variables. An interest rate spread specifically refers to the difference in interest rates, also called yield, of two related rates. The differences reflected in an interest rate spread can be based on fluctuations in currencies, perceptions of risk and inflation expectations, among other factors.

Types

An interest rate spread can have various meanings in several different contexts. One of the most common in macroeconomics is the difference in yield between two securities of different maturity, for example between a two-year and 10-year Treasuries. But it can also be a measure of risk when referring to the difference in yield between low risk assets, like U.S. Treasuries, and commercial rates, such as Eurodollar, of the same maturity (this particular example is known as the TED spread). When applied to a specific lending institution, the interest rate spread is a measure of profitability between the cost of short term borrowing and the return on long term lending.

Features

Interest rates are a measure of the cost of borrowing, and represent the return to the lender over time. The time to maturity is a major component of interest rates. In normal periods, a longer maturity represents a higher risk and therefore a higher rate. One reason for this is the risk of inflation. The TIP spread, the difference between the nominal yields on U.S. bonds and inflation-indexed securities of comparable maturity, is used as a measure of inflation expectations.

Function

For the average consumer, the most important interest rate spread is usually the difference between a benchmark rate and the rate they're offered on a loan or mortgage. The prime rate, for example, is extended to the highest rated borrowers, typically large institutions. Consumers are offered a rate several points above the prime rate, with the spread largely determined by their credit score (a measure of risk). The spread between the interest rate on a mortgage and the annual percentage rate (APR) reflects the fees and true cost associated with the transaction.

Significance

One of the most common uses of interest rate spread is to create a chart called the yield curve. The yield curve is not a single spread, but the plotting of the simultaneous yields of Treasuries at all maturities. The slope of the resulting curve is frequently used as a predictor of economic recessions. When the spread between short and long term Treasury yields is negative, meaning the yield on two-year rates exceeds the yield on 10-year rates, the odds of an economic recession within the next two years increases.