Bond market can be classified into various segments based on the nature of characteristics such as type of issuer (central bank, corporate etc.), credit risk (risk-free, AAA etc.), coupon level (zero coupon, high coupon or low coupon) and maturity (short-, medium-, or long-term) etc.
Any difference in the characteristics should cause a difference in the yield i.e., yield spread. When we consider the differences in maturity, then it will give rise to yield curve strategies.
Yield spread or spread strategies depend on the positioning of portfolio components to make gains from movements in yield spreads between different segments of the bond market. The major technique involved is bond swapping. Bond swapping implies exchanging an overvalued bond in the portfolio for another bond that the portfolio manager considers undervalued by the market. Both, undervaluation and overvaluation are measured in terms of spread. The spread is too wide in the case of undervaluation and it is too narrow in case of overvaluation. When the yield spread between the two bonds results in realignment, then the manager will capitalize the difference by reversing the bond swap.
The yield of the bond that is sold increases and the yield on the purchased bond decreases.
Yield spreads can be established from different sources. One of the significant yield spreads is credit spread. It implies bonds of lower quality trade at a spread with regard to higher quality bonds. This spread between low and high quality bonds will increase when the economy sets into recession and it will become narrow during boom phases, i.e., lower quality issuers will experience more difficulties in servicing their debt when the economic activity in general is low because subsequently their income from operations will also decrease. With this fact known, the portfolio manager will swap low quality bonds for high quality bonds when the economic activity is approaching its peak (flight to quality) and when the recession sets in the portfolio manager does the opposite.
Another significant source of spread to be noted is call provision. However, the probability that the issuer will exercise the call option is closely related to the level of interest rates and their volatility. The probability of exercising call option will decrease with the level of interest rates and will increase with the volatility of the underlying asset interest rate. In this way, the portfolio manager, on expecting a decrease in the level of interest rates, can swap callable for non-callable bonds as the spread is likely to increase.