Bond spreads asset-swap spread

Making comparison between bonds could be difficult and several aspects must be considered. One of these is the bond s maturity. For instance, we know that the yield for a bond that matures in 10 years is not the same compared to the one that matures in 30 years. Therefore, it is important to have a reference yield curve and smooth that for comparison purposes. However, there are other features that affect the bond s comparison such as coupon size and structure, liquidity, embedded options and others. These other features increase the curve fitting and the bond s comparison analysis. In this case, the swap curve represents an objective tool to understand the richness and cheapness in bond market. According to O Kane and Sen (2005), the asset-swap spread is calculated as the difference between the bond s value on the par swap curve and the bond s market value, divided by the sensitivity of 1 bp over the par swap. 

As shown in Eigures 1.4 and 1.5, with this swap structuring, the asset-swap spread for HERIM is 39.5 bp and for TKAAV is 39.1 bp. These represent the spreads that will be received if each bond is purchased as an asset-swap package. In other words, the ASW spread provides a measure of the difference between the market price of the bond and the value of the cash flows evaluated using zero-coupon rates. 

FIGURE 1.7 Historical asset-swap spread for bonds traded in the utility industry. (Data Source Bloomberg.)... 

Asset-swap spread It is determined by combining an interest-rate swap and cash bond. Generally, bonds pay fixed coupons therefore, it will be combined with an interest-rate swap in which the bondholder pays fixed coupons and receives floating coupons. The spread of the floating coupon over an interbank rate is the asset-swap spread. ... 

Figure 8.2 shows the Bloomberg YAS page for Tesco bond SVi% 2019, as at October 9, 2014. The bond has a price of 109.345 and yield to maturity of 3.46%. On the date, the yield spread over a government bond benchmark UK 41 % Treasury 2019 is 200 basis points. The G-spread over an interpolated government bond is 181.5 basis points. Conventionally, the difference between these two spreads is narrow. We see also that the asset-swap spread is 173.6 basis points and Z-spread is 166.3 basis points. 

Chapter 8 shows several spread measures that can be used to compare fixed-rate bonds. Conventionally for floating-rate notes, traders use the discounted margin. To analyse a floating-rate note with a fixed-rate note, one method is to compare the discounted margin of a floater with the asset swap spread of fixed-rate bonds. 

What is worthy then of a further investment of cash to purchase this second edition Hopefully the new chapters on asset swap spread relative value, convertible bonds, callable/putable bonds and floating-rate notes will be sufficient justification additionally we have updated the previous chapters on inflation-linked bonds and risky corporate bonds valuation. We have also included Excel spreadsheets that enable the reader to apply the analysis described in the chapters right away to bonds that he or she selects. 

There are several different measures of spread the two most common ones are spread to benchmark and asset swap spread/margin (ASM). The former is the difference in the yields of a bond and its corre-... 

The asset swap spread is equal to the underlying asset s redemption yield spread over the government benchmark, minus the spread on the associated interest rate swap. The latter, which reflects the cost of converting the fixed-rate coupons of benchmark bonds to a floating rate during the life of the asset, or the default swap, is based on the swap rate for the relevant term. 

Return from a holding of fixed-income securities may be measured in more than one way. The most common approach is to consider the asset-swap spread. More sophisticated investors also consider the basis spread between the cash bond and the same-name credit default swap price, which is known as the basis. In this chapter we consider the most accessible way to measure bond return. 

The I-spread is sometimes used to compare a cash bond with its equivalent CDS price, but for straightforward relative value analysis is usually dropped in favor of the asset-swap spread, which we look at later in this section. 

FIGURE 19.3 shows the Bloomberg screen ASW for a GBP-denomi-nated bond, GKN Holdings 7 percent 2012, as of August 10, 2005- We see that the asset-swap spread is 121.5 basis points. This is the spread over LIBOR that will be received if the bond is purchased in an asset-swap package. In essence, the asset swap spread measures a difference between the... 

Put simply, the Z-spread is the basis point spread that would need to be added to the implied spot yield curve such that the discounted cash flows of the bond are equal to its present value (its current market price). Each bond cash flow is discounted by the relevant spot rate for its maturity term. How does this differ from the conventional asset-swap spread Essentially, in its use of zero-coupon rates when assigning a value to a bond. Each cash flow is discounted using its own particular zero-coupon rate. The bond s price at any time can be taken to be the market s value... 

In practice, the Z-spread, especially for shorter-dated bonds and for better credit-quality bonds, does not differ greatly from the conventional asset-swap spread. The Z-spread is usually the higher spread of the two, following the logic of spot rates, but not always. If it differs greatly, then the bond can be considered to be mispriced. 

FIGURE 19.7 Bloomberg Graph Using Screen G , Plot of Asset-Swap Spread and CDS Price for GKN Bond, April-September 2005 ... 

The spread of the floating coupon over the bond s market price, that is the asset-swap value is the difference between the bond s market price and par. The package of the asset swap is structured in two phases ... 

The zero-coupon curve is used in the asset-swap analysis, in which the curve is derived from the swap curve. Then, the asset-swap spread is the spread that allows us to receive the equivalence between the present value of cash flows and the current market price of the bond. 

However, a critical issue on this spread measure is how the asset swap has been stmctured. ASW measure works very well when bond prices trade at or near to par. Most corporate bonds trade with price away from the par (as in this case), thus making the ASW an inaccurate spread measure. If the bond trades at premium, the ASW spread will overestimate the level of credit risk conversely, if the bond trades at discount the ASW spread will underestimate the level of credit risk. Therefore, in the case of HERIM and TKAAV, the ASW spread overestimates the credit risk associated with the bonds because both trade significantly at premium. 

A credit default swap (CDS) price provides fundamental credit risk information of a specific reference entity or asset. As explained before, asset swaps are used to transform the cash flows of a corporate bond for interest rate hedging purpose. Since the asset swaps are priced at a spread over the interbank rate, the ASW spread is the credit risk of the same one. However, market evidence shows that credit default swaps trade at a different level to asset swaps due to technical... 

If this difference is positive we have a positive basis, and it happens when credit derivates trade at higher prices than asset swaps. Otherwise, if the difference is negative we have a negative basis. Consider the following example of a positive basis trade for HERIM and TKAAV. For both bonds, we calculate the CDS spread which is equal to 86.3 for HERIM and equal to 88.6 for TKAAV. The CDS basis over the ASW spread determined before is equal to 46.8 for HERIM and equal to 49.5 for TKAAV. However, the basis illustrated in Figure 1.6 is different because CRVD measures them relative to the Z-spread, which is 50.7 for HERIM and 48 for TKAAV. The basis relative to the Z-spread is equal to 35.6 for HERIM and 40.6 for TKAAV. So, we note that either the ASW spread or the Z-spread can be used as the basis performance, giving a similar result and positive basis in both cases. 

Choudhry, M., 2005. An alternative bond relative value measure determining a fair value of the swap spread using libor and gc repo rates. J. Asset Manag. 7 (1), 17-21. 

That said, there are two reasons why the performance of German swap spreads are related to Euro peripheral spreads. The first one is that, flows apart, the bond-swap spread reflects the yield difference between a government rate and the composition of a string of EURI-BOR rates (i.e., a swap fixed rate). As the average credit quality of the banks in the EURIBOR panel is A-AA, any increase in the investors preference for credit quality will make both swap and peripheral spreads widen versus the core Euro government rate, thus increasing the correlation between both differentials. Yet this increase in the correlation will be mainly due to the outperformance of the benchmark asset... 

Asset swaps are used to alter the cash flow profile of a bond. The asset swap market is an important segment of the credit derivatives market since it explicitly sets out the price of credit as a spread over LIBOR. Pricing a bond by reference to LIBOR is commonly used and the spread over LIBOR is a measure of credit risk in the cash flow of the underlying... 

An example would be that a protection buyer holding a fixed-rate risky bond and wishes to hedge the credit risk of this position via a credit default swap. However, by means of an asset swap the protection seller (e.g., a bank) will agree to pay the protection buyer LIBOR +/-spread in return for the cash flows of the risky bond. In this way the protection buyer (investor) may be able to explicitly finance the credit default swap premium from the asset swap spread income if there is a negative basis between them. If the asset swap was terminated, it is common for the buyer of the asset swap package to take the unwind cost of the interest rate swap. 

Assume that an investor holds a bond and enters into an asset swap with a bank. Then the value of an asset swap is the spread the bank pays over or under LIBOR. This is based on the following components ... 

To buy this bond the investor would pay 105.3% of par value. The investor would receive the fixed coupons of 5.5% of par value. Let us assume that the swap rate is 5%. If the investor in this bond enters into an asset swap with a bank in which the investor pays the fixed coupon and receives LIBOR +/- spread. 

The asset swap price (i.e., spread) on this bond has the following components ... 

CDS prices are often compared to bond asset swap levels in order to gain an initial comparison of the credit quality implied by the market. In fact, differences do exist between the CDS spread and the asset swap spread, even though both spreads may be viewed as compensating the... 

Long credit risk (i.e., long the bond risk) Short credit risk (i.e., short the bond risk) CDS spread is higher than the asset swap level CDS spread is lower than the asset swap level Long asset and long protection Short asset and short protection Long-credit risk Short-credit risk... 

Asset Swap Basis The asset swap basis is the spread on the CDS minus the spread on a par asset swap of a bond with a similar average life. A positive basis exists when this difference is positive. 

Several borrowers issue bonds in multiple currencies, which tend to trade at different spreads, even on a fully asset swapped basis. The reasons for this divergence include name recognition, and technical factors such as liquidity and the ability to enter into a repo. 

Asset-swap pricing is commonly applied to credit-default swaps, especially by risk management departments seeking to price the transactions held on credit traders book. A par asset swap typically combines an interest rate swap with the sale of an asset, such as a fixed-rate corporate bond, at par and with no interest accrued. The coupon on the bond is paid in return for LIBOR plus, if necessary, a spread, known as the asset-swap spread. This spread is the price of the asset swap. It is a function of the credit risk of the underlying asset. That makes it suitable as the basis for the price payable on a credit default swap written on that asset. 

An asset swap is a package that combines an interest-rate swap with a cash bond, the effect of the combined package being able to transform the interest-rate basis of the bond. Typically, a fixed-rate bond will be combined with an interest-rate swap in which the bond holder pays fixed coupon and received floating coupon. The floating coupon will be a spread over LIBOR (see Choudhry et al. 2001). This spread is the asset-swap spread and is a function of the credit risk of the bond over and above interbank credit risk. Asset swaps may be transacted at par or at the bond s market price, usually par. This means that the asset swap value is made up of the difference between the bond s market price and par, as well as the difference between the bond coupon and the swap flxed rate. 

The conventional approach for analyzing an asset swap uses the bonds yield-to-maturity (YTM) in calculating the spread. The assumptions implicit in the YTM calculation (see Chapter 2) make this spread problematic for relative analysis, so market practitioners use what is termed the Z-spread instead. The Z-spread uses the zero-coupon yield curve to calculate spread, so is a more realistic, and effective, spread to use. The zero-coupon curve used in the calculation is derived from the interest-rate swap curve. 

---