The Futures Bond Basis, Second Edition

AppendixB

RELATIVE VALUE ANALYSIS: BOND SPREADS

Investors measure the perceived market value, or relative value, of a corporate bond by measuring its yield spread relative to a designated benchmark. This is the spread over the benchmark that gives the yield of the corporate bond. A key measure of relative value of a corporate bond is its swap spread. This is the basis point spread over the interest-rate swap curve, and is a measure of the credit risk of the bond. In its simplest form, the swap spread can be measured as the difference between the yield-to-maturity of the bond and the interest rate given by a straight-line interpolation of the swap curve. In practice, traders use the asset–swap spread and the Z-spread as the main measures of relative value. The government bond spread is also used. In addition, now that the market in synthetic corporate credit is well established, using credit derivatives and credit default swaps (CDSs), investors consider the Cash–CDS spread as well, which is known as the basis.

The spread that is selected is an indication of the relative value of the bond, and a measure of its credit risk. The greater the perceived risk, the greater the spread should be. This is best illustrated by the credit structure of interest rates, which will (generally) show AAA- and AA-rated bonds trading at the lowest spreads and BBB-, BB- and lower-rated bonds trading at the highest spreads. Bond spreads are the most commonly used indication of the risk–return profile ...