Fixed Income
Understanding G-Spread
When analysing bonds, investors often want to know how much extra return a bond offers compared with a risk-free benchmark. The G-spread is one of the simplest ways to answer that question. It measures the yield difference between a bond and a government security of similar maturity.
G-spread is widely used because it is easy to calculate and easy to interpret, especially for plain vanilla bonds.
What G-Spread Really Measures
The G-spread is the difference between a bond’s yield to maturity and the yield on a government bond with the same maturity.
In practical terms, it tells us how much additional yield an investor earns over a government bond for taking on extra risk, such as credit risk and liquidity risk.
G-spread assumes that the government yield curve represents a risk-free benchmark.
How G-Spread Is Calculated
The calculation is straightforward.
Take the yield to maturity of the bond.
Subtract the yield to maturity of a government bond with the same maturity.
G-Spread = Bond yield − Government bond yield
Exams usually test the interpretation rather than the arithmetic.
Why Government Bonds Are Used as the Benchmark
Government bonds are typically considered free of default risk, especially when issued by stable sovereigns. Because of this, they serve as a reference point for measuring additional risk in other bonds.
By comparing a corporate or non-government bond to a government bond, the G-spread captures the extra compensation investors demand for bearing non-sovereign risk.
Interpretation of G-Spread
A higher G-spread means the bond offers more yield relative to the government benchmark. This usually reflects higher credit risk, lower liquidity, or both.
A lower G-spread suggests the bond is closer in risk profile to a government security.
G-spread is best used for comparison across bonds with similar maturities and structures.
G-Spread Versus I-Spread
This comparison appears frequently in exams.
G-spread uses a government bond yield as the benchmark.
I-spread uses a swap rate as the benchmark.
Because swap rates reflect interbank credit risk, I-spreads are often more stable across maturities than G-spreads.
Understanding the benchmark difference is more important than memorising definitions.
G-Spread Versus Z-Spread
G-spread compares yields at a single maturity point.
Z-spread adjusts the entire yield curve by a constant spread.
For bonds with fixed cash flows, Z-spread provides a more precise measure. G-spread is simpler but less refined.
Exams may test which spread is more appropriate in different contexts.
When G-Spread Works Best
G-spread works well when:
- Bonds have no embedded options
- Cash flows are fixed
- A clear government benchmark exists
It is commonly used for corporate bonds and sovereign-related issuers.
For bonds with embedded options, G-spread becomes less reliable.
Limitations of G-Spread
One limitation is that it relies on a single point on the yield curve. This ignores changes in curve shape.
Another issue arises when government bonds are affected by supply, demand, or policy distortions. In such cases, the G-spread may not reflect true credit risk accurately.
These limitations are often tested conceptually in exams.
Common Exam Confusions
Students sometimes assume G-spread measures only credit risk. It actually captures both credit and liquidity risk.
Another common mistake is applying G-spread to callable or putable bonds without recognising the impact of embedded options.
Exams may also test whether candidates understand that G-spread is maturity-specific.
Final Thought
G-spread is a simple and intuitive spread measure that compares a bond’s yield with a government benchmark. While it lacks the sophistication of curve-based measures, it remains useful for analysing plain vanilla bonds. For exam preparation, focus on what G-spread measures, when it is appropriate to use, and how it differs from other spreads. Once these ideas are clear, G-spread questions become straightforward.
