Maturity benchmark government

Traditional yield spread analysis for a nongovernment bond involves calculating the difference between the risky bond s yield and the yield on a comparable maturity benchmark government security. As an illustration, let s use a 5.25% coupon BMW Finance bond described in Exhibit 3.10 that matures on 1 September 2006. Bloomberg s Yield Spread Analysis screen is presented in Exhibit 3.14. The yield spreads against various benchmarks appear in a box at the bottom left-hand corner of the screen. Using a settlement date of 9 July 2003, the yield spread is 31 basis points versus the interpolated 3.1-year rate on the Euro Benchmark Curve. This yield spread measure is referred to as the nominal spread. 

Naturally, this presupposes the reference rate used for the floating-rate cash flows is EURIBOR. Furthermore, part of swap spread is attributable simply to the fact that EURIBOR for a given maturity is higher than the rate on a comparable maturity benchmark government. 

Cash flow is simply the cash that is expected to be received in the future from owning a financial asset. For a fixed-income security, it does not matter whether the cash flow is interest income or repayment of principal. A security s cash flows represent the sum of each period s expected cash flow. Even if we disregard default, the cash flows for some fixed-income securities are simple to forecast accurately. Noncallable benchmark government securities possess this feature since they have known cash flows. For benchmark government securities, the cash flows consist of the coupon interest payments every year up to and including the maturity date and the principal repayment at the maturity date. 

The minimum interest rate that an investor should require is the yield available in the marketplace on a default-free cash flow. For bonds whose cash flows are denominated in euros, yields on European government securities serve as benchmarks for default-free interest rates. In some European countries, the swap curve serves as a benchmark for pricing spread product (e.g., corporate bonds). For now, we can think of the minimum interest rate that investors require as the yield on a comparable maturity benchmark security. 

The general rule of corporate bonds is that they are priced at a spread to the government yield curve. In absolute terms, the yield spread is the difference between the yield to maturity of a corporate bond and the benchmark, generally a yield to maturity of a govermnent bond with the same maturity. Corporate bonds include a yield spread on a risk-free rate in order to compensate two main factors, liquidity premium and credit spread. The yield of a corporate bond can be assumed as the sum of parts of the elements as shown in Figure 8.1, in which the yield spread relative to a default-free bond is given by the sum of default premium (credit spread) and liquidity premium. 

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. 

The most actively traded government securities for various maturities are called benchmark issues. Yields on these issues serve as reference interest rates which are used extensively for pricing other securities. Exhibit 1.2 is a Bloomberg screen of the benchmark bonds issued by the government of the Netherlands. European government bonds will be discussed in Chapter 5. As an illustration of a corporate bond. Exhibit 1.3 shows a Bloomberg Security Description screen for 4.875% coupon bond issued by Pirelli SPA that matures on 21 October 2008. 

In the pre-euro days, traders were usually organized by currency. Now, sector specialization is the rule. For most issues, buy or sell indications are initially indicated on a spread basis. The spread can be either over the swap curve or over a specified government benchmark. A corporate bond issue keeps the same benchmark for its entire life they roll down the curve together. This is in contrast to the United States, where the convention is to quote a corporate bond s spread over the nearest on-the-run (most recently issued) 2-, 5-, 10-, or 30-year maturity Treasury bond. 

Once issued the yields on government bonds across different maturities provide a benchmark for yields on other less creditworthy bonds. 

After assessing a bond with the help of credit analysis, the question arises to what extent the market price of this bond corresponds with the investor s judgement. The market price should compensate the investor for all risks connected with holding the bond. This market price (spread) is often referred to as the return differential between the analysed bond and the benchmark. Frequently, government bonds or the swap rate with matching maturities are used as benchmarks. Another standard reference are bonds of other issuers that are active in the same business field. Since one debt instrument is assessed relative to another debt instrument, this analysis is also called relative value analysis, the basic principles of which are described in this section. 

A bank s swap screen on Bloomberg or Reuters might look something like FIGURE 7.3. The first column represents the length of the swap agreement, the next two are its offer and bid quotes for each maturity, and the last is the current bid spread over the government benchmark bond. 

The note in figure 13.3 pays a coupon equal to the current 2-year government benchmark plus a fixed spread of 1 percent. It has a legal maturity of six years, but it will mature in three years if, two years from the issue date, 6-month LIBOR stands at 6 percent or below. Amortization takes place on subsequent rate-fixing dates according to the specified schedule. If at any time less than 20 percent of the nominal value remains, the note is canceled. 

IDNs can be structured to enable investors to take positions on the yields in different currencies at the same maturity. A note s coupon, for example, could be determined by the difference between the 10-year government benchmark yields in two specified countries. The notes can also be linked to spreads between yields at different maturities in the same currency. This would be a straight yield-curve, or relative-value, trade in a domestic or foreign currency. 

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