Spread Compression
The narrowing of bid-ask spreads or yield spreads, driven by increased market liquidity or falling risk premiums.
What is Spread Compression?
Spread compression refers to the narrowing of the difference between two related prices or yields in financial markets. In equity trading, spread compression describes the tightening of bid-ask spreads—reduced transaction costs for investors—associated with higher market liquidity, increased competition among market makers, and greater trading volume. In fixed income, spread compression describes the narrowing of yield spreads between corporate bonds and Treasury benchmarks, typically occurring when investors become more comfortable with credit risk and demand less compensation for holding riskier debt. While spread compression benefits investors through lower costs or higher bond prices, it can squeeze market maker profitability and signal excessive risk-taking during credit cycles. The decimalization of U.S. stock prices in 2001 was a structural driver of equity bid-ask spread compression.
Example
During the low-rate environment of 2021, investment-grade corporate bond spreads compressed to near-record lows as investors seeking yield aggressively bought corporate debt, reducing the extra yield premium above equivalent Treasury rates to roughly 80 basis points—well below the historical average of 130 basis points.
Source: Investopedia — Bid-Ask Spread