To price or mark-to-market a fixed income obligation, such as a bond, market participants must assume some yield to maturity (YTM) or an entire spot curve for discounting future cash flows. Many factors influence the choice of YTM or spot curve that is used to value a particular obligation. Depending upon the nature of the obligation, these might include:
current market interest rates;
the maturity of the obligation;
credit risk of the obligation;
the liquidity of the obligation;
embedded options; and
tax treatment of the obligation.
Current market interest rates are reflected by some benchmark yield curve or spot curve. Since these are term structures, they reflect the maturity dependence of interest rates. For USD-denominated instruments, Treasuries are often used as a benchmark. The swap curve is also used.
Contributions of other factors are modeled as yield or interest rate spreads over the benchmark curve, so the YTM or spot curve at which a particular obligation's cash flows are discounted is modeled as a benchmark curve plus a spread for credit risk, plus a spread for liquidity, plus a spread for embedded options, etc. This is illustrated for a hypothetical callable corporate bond.
It should be emphasized that these spreads comprise a model for valuing an obligation. In many cases, individual spreads are not observable in the market. All that is observable is benchmark yield or spot curves and instrument prices. Based upon these, various spreads may be inferred.
Note that the spreads in Exhibit 1 are constant across all maturities. This is a standard simplifying assumption. More sophisticated models might permit spreads to vary by maturity.
Spreads due to optionality arise with instruments such as callable bonds or mortgage-backed securities (MBS), which have embedded options. Generally, the options are structured to the investor's disadvantage, so the instruments they are embedded in trade at lower prices—higher spreads—than comparable instruments that lack embedded options. Spreads due to optionality are generally inferred using option-adjusted spread analysis.
Many instruments do not have liquid secondary markets, and their prices are depressed for this reason. This is reflected in a liquidity spread. Liquidity spreads are apparent in the secondary market for US Treasury securities. The most recently issued Treasuries are said to be on-the-run. There is a liquid secondary market for on-the-run Treasuries. Other Treasuries are said to be off-the-run, and they have less of a secondary market. Because they are less liquid, off-the-run Treasuries routinely trade at spreads over comparable on-the-run Treasuries. This is illustrated in Exhibit 2. On November 16, 2000, 174 distinct Treasury securities were trading. Exhibit 2 plots YTM against maturity for all of these. At most maturities, the on-the-runs are trading at 15 to 20 basis points below the off-the-runs.
Note that liquidity spreads are distinct from bid-ask spreads. The latter also depend upon liquidity. A distinction is that mid-market rates are unaffected by the magnitude of the bid-ask spread. They are affected by the magnitude of any liquidity spread, which shifts both the bid and offer rates in the same direction.
Credit spreads reflect the particular nature of an obligation. For example, senior debt generally has higher credit quality than subordinated debt of the same issuer. They also reflect the financial condition of the issuer, the issuer's industry and the issuer's home country.
If an obligation has both credit and liquidity spreads, it may be difficult to separate these into two distinct spreads. As a practical matter, it is rarely necessary to do so.
Tax spreads are generally negative spreads reflecting tax advantages of certain obligations. In the United States, income from most municipal bonds is exempt from federal taxation. Consequently, investors in the highest tax brackets bid up the prices of municipal bonds so that their YTM's are comparable to the after-tax YTM's of other comparable bonds. Elton et al (2001) suggest that much of the credit spread between high-quality corporate bonds and US Treasuries can be attributed to the fact that Treasuries are not taxed at the state level while corporates are.
Another example of tax spreads is flower bonds. Between 1953 and 1963, the US Treasury issued a number of Treasury bonds with a special feature. If tendered as payment of federal estate taxed, the bonds would be valued at par, irrespective of their current market value. Because of their association with estate taxes and funerals, the bonds came to be called flower bonds. When interest rates rose during the 1970s and 1980s, flower bonds traded at a premium. The last flower bond had a coupon of 3.5% and matured in 1998.
Other factors may also contribute to yield or interest rate spreads. Random "noise" in bond prices quoted by dealers is one example. Because bonds tend to trade in large blocks, it is difficult for arbitragers to eliminate minor price discrepancies. Aguais et al. (1998) argue that there is also a cost-of-carry for holding corporate bonds. This might be 15 basis points for highly rated short-term obligations.