Spreads and Market Pricing Methods
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Securities issued by a country’s national government set the benchmark borrowing rate for all other domestic debt issuers that borrow in that particular country’s currency. To attract capital, all other borrowers must offer incentives. In most cases, incentives take the form of additional yield, otherwise known as the spread.
Spread Definition- A spread is the difference between the yields on two debt securities, normally expressed in basis points. For example, if the yield on Bond X is 5% and the yield on Bond Y is 5.55%, then the spread of Bond Y over Bond X is 55 basis points.
Spreads are used to compare the yield of one bond to another. In most cases, the bond used as the standard or reference is the domestic national government bond of similar maturity. The spread between the two bonds reflects the difference in risk between the two securities. The primary risk reflected is the credit risk associated with the non–government bond. However, the spread also reflects all other incremental risks faced by the owners of the non–government bonds. Besides credit risk, the most significant incremental risks are option and liquidity risk. In general, the greater the difference in the risks of the two securities, the larger the spread. Entire domestic bond markets trade on the concept of spreads. The market moves according to flows in benchmark government issues because every trade in a bond almost always triggers another trade in a government bond with a comparable term or duration. That bond in turn is priced relative to a benchmark issue. As a result, bond prices change frequently.
SPREAD DETERMINATION
The basic premise behind spreads is that they compensate investors for taking on additional risks over the risks associated with domestically-issued national government bonds. Investors in non-national government bonds incur three primary risks:
» Credit risk
» Option risk
» Liquidity risk
Credit risk- This is issuer’s ability to make timely payments of interest and principal. If payment is not made on time, the issuer is said to be in default. The risk that an issuer may default on payments (interest, principal, or both) is called default risk (or, more commonly but less precisely, credit risk).
Bond investors should be aware of the impact credit risk changes can have on the value of their portfolios. They therefore commit resources to ensure that the credit risk in their portfolios is appropriate at all points in time. Market participants use credit ratings as an important consideration in determining the additional yield (called the yield spread) these debt securities provide over government issues.
CREDIT ANALYSIS
The purpose of credit analysis is to evaluate an issuer’s ability to service and repay its debt. Here are the key steps:
1. Determine the issuer’s existing obligations.
2. Identify the assets that are available as protection for debt holders in the event of a default. 3. Analyse liquidity and borrowing needs
4. Analyse profitability.
5. Analyse cash flow needs.
Option Risk
Some corporate bonds contain a type of option. The effect of the option on the spread of the bond relative to an otherwise equivalent option-free bond depends on whether the option benefits the issuer or the investor. If the option benefits the issuer, the spread will be greater than the spread of an otherwise equivalent option-free bond; if the option benefits the investor, the spread will be less. There are three primary types of embedded options: calls, puts, and conversions. Call options benefit the issuer, whereas put options and conversion options benefit the investor.
Liquidity Risk
The liquidity of bonds depends on whether they are on-the-run or off-the-run. On-the-run bonds are the bonds that have been issued most recently. They trade close to par, are the most liquid issues, and are generally used as bond market yield benchmarks. Alternatively, off-the-run bond issues are not traded as frequently as the benchmark on-the-run bonds and are therefore less liquid. Liquidity is an important factor in the decision to participate in a market because it determines the holder’s ability to buy and sell positions quickly and with little impact on price. Liquidity is a function of both the outstanding size of the issue and the volume traded. The benchmark federal government bonds are invariably the most liquid bonds in a domestic bond market. In India, the most liquid bond in the secondary market is the 10-year G-sec. Turnover of these bonds (i.e., daily trading volume) is normally many times that of most other bonds, including off-the-run federal government bonds. A lower level of liquidity translates into greater risk for investors because of the wider bid-ask spread associated with less liquid issues. This means that the bond must be bought or sold at a value further from its true value, which is represented by the mid-point of the bid-ask spread.