Handbook of Finance: Financial Markets and Instruments

Chapter 45. Bond Spreads and Relative Value

MOORAD CHOUDHRY, PhD

Head of Treasury, KBC Financial Products, London

Abstract: Bond spreads are used to determine relative value in bonds that are not credit risk free. This relative value is a measure of the risk premium return implied in the bond yield. To calculate bond spread, we may use one of four different measures, which are described and illustrated in this chapter. Investors can also determine relative value in the cash market by comparing its yield spread with that observed in the synthetic market, which is represented by the credit default swap premium payable for the same reference name. The spread difference between the two markets is known as the credit default swap basis and the existence of the basis implies arbitrage opportunities between the two markets.

Keywords: asset swap, credit default swaps (CDSs), basis, bond spread, interpolated spread, relative value, swap spread, zero-volatility spread (Z-spread)

In this chapter we consider the methods by which the value of a bond can be ascertained by comparing its yield to that of another bond or benchmark interest rate. Whichever method is used to calculate it, this measure is important for investors, as it is an indication of relative value and, as such, the main method by which they gauge whether it is worthwhile to hold the bond and if its risk-reward profile is acceptable. The methods that can be used reflect the differences in measuring yield in cash and derivative markets, ...