What is the spread?

In finance, spread is a generic term that indicates a difference between the prices, the yields or the interest rates of two financial instruments.

This difference can be a very useful indicator for investors. For instance, if we compare two bonds with the same characteristics (maturity, type of interest rate, currency and so on) but issued by two different subjects, the spread reflects the difference in the capacity of the two issuers to refund the borrowed money (or rather, how investors assess this capacity over time).

However, when talking about the spread, the non-specialised press refers to a very specific difference, the one between the yield on an Italian government security, a BTP (Treasury bond), with a ten-year maturity, and the yield on a German government security, a Bund, with the same maturity.

Let's remember that the higher the yield on a security, the higher the risk taken.

Germany was chosen as the benchmark as it is considered to be the most trustworthy country in the Eurozone. The higher the spread, the riskier the Italian security is considered to be in comparison with the German one.

Therefore, the spread is a measure of how investors perceive the Italian state to be riskier than the German state in its capacity to refund money borrowed by issuing government securities.

Why does the spread increase?

Every year, Italy issues new debt, and every year somebody has to buy that debt, i.e. state bonds: buyers could be Italian savers, retirement funds, insurance companies and investment funds.

If their perception of the State's ability to refund the debt gets worse, these investors will demand higher interest rates and the spread will therefore tend to go up.

However, the spread can vary even when the investors' assessment of states' ability to refund the debt doesn't. This happens at times when investors become more risk averse, i.e. less willing and able to handle potential losses, typically during financial crises when there is a lot of uncertainty over the economic outlook.

How can an increase in the spread affect your financial choices?

If you have already invested your savings in government securities, the increase in the spread generally corresponds to a decrease in your bonds' value (when yields go up, bond prices go down).

On the other hand, if you are thinking of buying a government security, you could earn a higher yield than before, but it's important to understand what the bigger risks are that are pushing the spread up.

For those who have a mortgage, on the other hand, the effects of an increase in the spread are quite limited. If you have a fixed-rate mortgage, by definition the payments don't change over the whole duration of the loan. If you have a variable-rate mortgage, an increase in the spread doesn't automatically mean a payment increase because the most widely used reference rates, such as the Euribor, are not closely connected to the spread trend.