BOSTON (TheStreet) -- Bond investors use Treasury yields as a benchmark because these government-issued notes are as risk-free as a security can be.The performance of a corporate bond is often measured against a comparable Treasury. The difference, or yield spread, can seem like an esoteric gauge to many investors. But understanding spreads can help investors identify bonds headed for a correction. The spread for a bond is simply the difference between its yield and the yield of a comparable Treasury security. The spread between the two securities reflects the risks they pose, such as those related to credit, liquidity and market forces. Spreads should be consistent for bonds with similar credit ratings, one of the biggest factors in determining the value of a bond. Fixed-income investors use spread changes to help them pick attractively priced bonds. Spreads typically return to their long-term averages over time. So when a spread expands above the average, corporate securities look cheap because the rates on these bonds have increased, pushing down the prices. The chart below shows the 10-year corporate bond spread for AAA-rated and BBB-rated securities over 10-year Treasury yields, and the historical average of the spread. During the turbulence of 2008 and 2009, these spreads reached unprecedented levels.
Even though corporate spreads remain wide, that doesn't mean that every corporate bond is priced at a discount. Johnson & Johnson's 6.95% 9/29 bond currently has a spread of about 113 basis points, a bit less than the average and about in line with the long-term average. Spread levels can also help investors protect against losses. If spreads start to widen, bond investors should look into the underlying causes. If the problem reflects concerns about credit quality rather than simple market gyrations, it may be time to trade out of corporate bonds and seek shelter in Treasuries. As the graph shows, the spreads of lower-quality issues expanded by more than those of high-quality securities. During the downturn, investors dumped junk bonds and put their money in bonds with higher credit ratings. Owning lower-quality bonds can result in bigger returns as spreads narrow, but the potential for default and liquidity risk increase dramatically compared with those of higher-rated securities, so investors need to be cautious. Comparing spreads is a more objective way to find fixed income bargains than sizing up bond yields. Investors who bought corporate bonds when their spreads were at their widest probably reaped huge rewards. Don't expect to see similar levels anytime soon, if ever, but monitoring spread changes can help investors make moderate gains and protect against losses. -- Reported by David MacDougall in Boston.