Fixed income is all about cash flows and the time value of money. Interest rates are a way of expressing the time value of money, and interest rate risk describes the present value risk associated with known, hedgeable cash flows given changes in the time value of money. Bond spreads, on the other hand, capture the value of cash flow uncertainty and lack of complete hedgeability, and spread risk describes the present value risk associated with uncertain cash flows, given changes in that uncertainty or hedgeability.
Cash flow uncertainty breaks into two major categories: uncertainty regarding timing of cash flows and uncertainty regarding the realized amount of cash flows. The dominant forms of cash flow uncertainty for fixed income revolve around prepayments, defaults, and loss severity. Prepayment and default risk deals with uncertainty regarding the timing of scheduled cash flows, while loss severity risk deals with the uncertainty regarding the realized amount of scheduled cash flows. A bond’s spread, then, is the excess rate of return over the internal rate of return on known, hedgeable cash flows, required to compensate for the combination of prepayment, default, loss severity, and liquidity risks.
We begin this chapter with a more concrete definition of spread. Bond spread is very dependent on the nature of that bond’s cash flows, and we will touch on the approaches to computing bond spread taken by the major ...