Yield spreads have narrowed dramatically since the blow-out three years ago. They returned to more normal levels as the financial market regained its legs with support from gratuitous government funding. Bond investors look to yield spreads as indicators of both financial health and market demand.A yield spread is simply the difference between two different types of bonds. It is quoted as a 1/100th of a percent, known as a basis point or bps (ie 0.01 percent equals one bps). Whereas yield spreads have revisited historic norms, what now may be forcing yield spreads wider is an onslaught of new bond issuance, with supply likely to outweigh demand.The overall US bond market grew 9.9 percent last year to $49.7 trillion, according to data from BOA/Merrill Lynch. The high-quality investment-grade market expanded by only 3.7 percent in 2010 versus a growth of 25 percent in 2009. The junk bond market grew by 17.8 percent in 2010, up from 4.4 percent in 2009. The lack of the supply of investment grade bonds prompted investors into the lesser quality corporate and foreign sovereign debt markets. This resulted in a narrowing of those yield spreads.Also as a result of improved financial market conditions, the yield spread between US treasury bonds and speculative or ‘junk’ bonds approached its pre-crisis low at 835 bps, or 8.35 points above the Treasury yield. The JPMorgan Chase data tracks the emerging market yields over Treasuries at 239 bps. Both yield spreads have widened slightly in 2011.In the US, the yield spreads are compared to the yield on US Treasuries. Spreads could be as calculated for corporate bonds of varying quality as discussed above, such as investment grade or speculative grade. These spreads are typically based on comparable bonds with a 10-year term. Other types of yield curves are to various maturities, such as a shorter-term bond to a longer term bond. The spread between the 2 year and the 10-year US Treasury bonds is currently in the range of 275 bps, with the 10-30 year spread at 120 bps or a 10-year yield of around 3.15 percent.Intra Europe, the spreads are based on the German government Bund yield. The troubled Spanish government debt is sitting at 5.29 percent, which is 214 basis point over the 3.15 percent comparable German bund. Whereas the rescued Greek 10-year yield spread exploded to 834 basis points to a yield of 11.5 percent, the Irish bond spread widened to 582 or a yield of just under nine percent. The yield spread for Portugal was less wide at 366 bps with a more modest yield of 6.8 percent after claims its government is solvent.A common gauge of the confidence in financial institutions is the TED spread. This stands for the Treasury Euro-Dollar. It is calculated by subtracting the interest rate on short-term Treasury bills from three-month dollar LIBOR interest rates. LIBOR stands for London Interbank Offered Rate. It is the rate at which the highest credit institutions can borrow in US dollars. Currently the TED spread is 14.3 bps. It tends to run in the range of 20 bps. When it is low, banks are considered a low risk and they can borrow money at close to the ‘risk-free’ rate of the US Treasury bills. In comparison, the TED spread widened to a record 460 basis points on October 10, 2008 when the financial markets hit the wall.None of the yield spreads are static and they can change dramatically as conditions in the economy change. That is why they are usually seen as charts over time, known as historical trend lines. The simplicity of the graph communicates significant amounts of information upon which to act. Based on the type of yield spread and the trend line, bond managers implement varying investment strategies.When the yield spreads are different than the historic average, investors expect a reversion to that mean or average. Any narrowing of the wide yield spreads might result in higher bond prices, while when spreads widen bond prices could rise as the spread returns to the average.There are five basic bond yield spread trading strategies. Each has a role to play and they can be utilised in combination. The first is the ‘duration spread’. This captures varying interest rates for bonds of varying maturities. A second type of spread is the ‘credit spread’. This compares interest rates between Treasuries, investment grade, and/or speculative bonds. Credit spreads narrow when investors are have more confidence that corporate bonds will not default and demand less of a premium for taking the risk.A third yield spread is a ‘coupon spread’. This reflects differences in interest rates stated on the original bonds when issued. That is the coupon rate. The coupon will be different between corporates or municipals or other tax advantaged bonds because of the impact of the tax rates. Any spreads out of the ordinary might point to mis-pricings that can be captured.The fourth common spread version is the ‘liquidity spread’, which focuses on how easy it is to buy or sell a bond. A Treasury Bill or T-bill is most liquid, with smaller issues from lesser known companies less liquid. Market disruptions can affect liquidity spreads as seen in 2008. The fifth common spread instrument is the “swap spread’. This compares the different yields between a fixed interest rate bond and a floating rate bond and tracks anticipated changes in the economy or policy.Bonds are an important part of the investment strategy for institutions and for individuals. They may be considered simple interest-paying financial instruments. Maximising the total return on investments in a portfolio of bonds is a complex matter. Yield spreads and curve strategies provide a means for understanding the dynamics that impact bond values. They are an elegant means of communication.Patrice Horner holds an MBA in Finance, a FINRA Series 7 License, and is a Certified Financial Planner (CFP-US). Any opinions expressed in this article are not specific recommendations, nor endorsements of any products. Individuals should consult with their banker, insurance agent, lawyer, accountant, or a financial planner for advice to address their personal situations.