Friday, December 4, 2009

Credit Spreads Explained

  • Credit investors need a measure to determine how much they are being paid to compensate for assuming the credit risk. Such measure of credit quality should enable comparison between securities issued by a company and also between securities issued by other companies
  • YTM Assumptions:
    • Investor can only achieve a return equal to the yield if the bond is held to maturity and if all coupons can be reinvested at the same rate
    • Assumes yield curve is flat i.e. in practice we would expect different rates for different maturity. In YTM reinvestment rates are same for all maturities
  • Yield Spread: Difference between YTM of bond and the associated on the run (most recently issued) treasury with similar but not identical maturity
    • It shares all the weaknesses of YTM in terms of reinvestment rate and hold to maturity
    • Another disadvantage is that it is not a measure of return of a long bond
    • It can only be used to compare different bonds with same maturity which may have different coupons
    • Benchmark security is chosen to have maturity close to but not coincident with bond which means that measure is biased if the underlying benchmark is sloped
    • Benchmark security can change over time as the bond rolls down the curve. Thus, it is not a consistent measure through time
  • Interpolated spread: I-Spread is the difference between YTM of the bond and interpolated yield to the same maturity on an appropriate reference curve
    • Overcomes the issue of maturity mismatch but does not correspond to the YTM of a traded reference bond
    • If the reference curve is upward sloping and the benchmark has a shorter maturity then I-spread will be less than the yield spread and vice versa
    • Accounts for shape of the term structure in a crude way
  • Option Adjusted Spread (OAS): Parallel shift to the LIBOR zero rate curve required in order that the adjusted curve re-prices the bond
    • Typically measured against LIBOR and was originally conceived as a measure of the amount of optionality priced into a callable and puttable bond
    • Reflects a parallel shift of the spread against LIBOR thus takes shape of the term structure into account
    • Assumes that cash-flow can be reinvested in LIBOR+OAS
    • OAS is higher than I-spread when reference curve is upward sloping and is less when the curve is inverted. The magnitude depends on the compounding frequency
  • Asset Swap Spread (ASW): Spread paid over LIBOR on the floating leg in a par asset swap package
    • It is a traded spread rather than an artificial measure
    • 2 components:
      • At initiation investor pays par and receives the bond, which is worth its fill price
      • Investor enters into an interest rate swap paying fixed cash-flows that are identical in size and timing to the coupon of the bond. In return, the investor receives a fixed spread over LIBOR called ASW
    • If the assets (bond) in ASW defaults then unwind cost is taken by the buyer. The loss is P-R i.e. difference between price paid and the recovery price
    • Increase in bond price results in fall in the ASW as the implied credit risk of the issuer decreasing
  • Quoted Margin (QM): Spread over the LIBOR paid by floating rate note. Analogous to coupon for fixed rate bond
    • Not a dynamic measure as it reflects the credit quality of the issuer on the issue date of the bond
  • Discounted Margin (DM): Fixed add-on to LIBOR that is required to re-price the bond. Analogous to YTM for fixed rate bond
    • Assumes underlying reference curve is flat
    • Measures yield relative to current LIBOR and does not take the term structure into account
    • Assumes that all future realized LIBOR rates will be equal to current LIBOR rate
  • Zero Discount Margin (Z-DM): Parallel shift to the forward LIBOR curve that is required to re-price the FRN. Analogous to OAS or zero volatility spread (Z-Spread)
    • Forward LIBOR rates are used to project the cash-flows and adjusted by Z-DM to calculate the discount rates
    • For upward sloping yield curves, Z-DM is less than DM
  • Credit Default Swap Spread (CDS-spread): Premium paid to a protection seller in CDS contract. Analogous to ASW
    • Measures compensation to an investor for taking on the risk of losing par minus the recovery rate of the bond
    • Arguably the best measure of credit risk for several reasons:
      • Almost a pure credit play with low interest rate risk
      • Corresponds to realizable stream of cash-flows
      • Investor can trade CDS to a number of fixed terms so we should be able to observe a term structure
      • CDS market is relatively liquid

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