Asset-Swap Spreads and Relative Value Analysis

Chapter Contents

Readers will be familiar with the basics of bond market instruments. We begin this book with a look at the use of asset swaps (ASW) and ASW spreads to determine relative value in a risky bond. Such analysis is a key part of the security selection decision. ASW spreads have been long in use in the market because the interest-rate swap (IRS) is an important reference for the bond market and is used to hedge the IR risk of bonds. This type of derivate contract typically exchanges a fixed rate interest payment to the floating one, and represents a fundamental tool in terms of hedging, speculation and managing risk. The spread between swap and bonds can be used to determine the relative value of the bond, but can be measured in several ways. It is, therefore, important to know which method is being used and quoted. Once known, the spread is taken to indicate the richness or cheapness of bonds with different features.

1.1 Asset-Swap Spread

The asset swap is an agreement that allows investors to exchange or swap future cash flows generated by an asset, usually fixed rates to floating rates. It is essentially a combination of a fixed coupon bond and an IRS. We define it thus:

A bond’s swap spread is a measure of the credit risk of a bond relative to the interest-rate swap market. Because the swap is traded by banks, or interbank market, the credit risk of the bond over the interest-rate swap is given by its spread over the IRS. In essence, then the IRS represents the credit risk of the interbank market. If an issuer has a credit rating superior to that of the interbank market, the spread will be below the IRS level rather than above it.

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:

• At issue, the investor pays the asset (cash bond) at par;

• At the same time, the investor enters in the swap contract, paying fixed cash flows equal to the coupon payment and receiving a fixed spread over the interbank rate, that is the asset-swap spread. Figure 1.1 shows the asset-swap mechanism.

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.

In an asset-swap contract, the investor assumes the credit risk of the bond. In case the bond defaults, the investor will continue to pay the swap, without receiving the coupons and the redemption value at maturity. Therefore, the buyer of the bond takes the default exposure of the bonds. Figure 1.2 illustrates the bond’s yield decomposition.

1.2 Swap Spread for Richness and Cheapness Analysis

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.

=PInterbankrate−PFullPV01

where PInterbank rate is the bond’s value discounted at interbank rate; PFull is the market price of the bond and PV01 is the sensitivity of 1 bp on the coupon payment.

Let us now consider the following example of bonds issued by two companies operating in different industries. The first one is Hera S.p.A., an Italian company operating in the utility industry that issued the bond HERIM 3¼% 2021 (hereinafter HERIM); the second one is Telekom Finanzmanagement GmbH, a German company operating in the telecommunications industry that issued the bond TKAAV 3⅛% 2021 (hereinafter TKAAV). Therefore, both companies issued two bonds with similar features:

• The same time to maturity (8 years);

• Similar issue date (4 October 2013 for HERIM and 3 December 2013 for TKAAV);

• Similar maturity date (4 October 2021 for HERIM and 3 December 2021 for TKAAV);

• The same creditworthiness with a Bloomberg composite rating of BBB;

• The same currency (EUR);

• The same coupon payment (3.250% for HERIM and 3.125% for TKAAV, annual frequency payment);

• The same bond structure (bullet as maturity type, no embedded options).

Figures 1.4 and 1.5 show the Bloomberg screen for ASW analysis. To calculate the ASW spread, we use the bond’s price, which is equal to 115.138 for HERIM and 114.592 for TKAAV. The swap structuring has been performed as follows:

• The same frequency payment as well as the bond’s coupon structure, in this case annual;

• The same day count convention, in this case actual/actual;

• Euro swap curve as reference interbank curve, coherent with the bond’s currency (EUR).

Depending on the reference yield curve selected and its currency denomination, the ASW spread changes. Figure 1.3 shows the ASW spread for different reference yield curves for TKAAV.

As shown in Figures 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.

However, a critical issue on this spread measure is how the asset swap has been structured. ASW measure works very well when bond prices trade at or near to...