Yield Spread, Interest Rate Spread, Credit Spread, Liquidity Spread, Tax Spread

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Interest Rate Spreads</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"> <p class="word_list"> <a href="#Credit spreads">credit spread</a><p class="word_list"> <a href="#flower bonds">flower bond</a><p class="word_list"> <a href="#liquidity spread">liquidity spread</a><p class="word_list"> <a href="#Tax spreads">tax spread</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"> <p class="word_list"> <br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table5"> <tr> <td align="right" width="9" height="14"></td> <td width="300" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body">To price or <a href="../articles/valuation.htm">mark-to-market</a> a fixed income obligation, such as a <a href="../articles/coupon_bond.htm">bond</a>, market participants must assume some <a href="../articles/yield.htm">yield to maturity</a> (YTM) or an entire <a href="../articles/fixed_income_term_structure.htm">spot curve</a> 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:</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">current market interest rates;</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">the maturity of the obligation;</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/credit_risk.htm">credit risk</a> of the obligation;</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">the <a href="../articles/liquidity.htm">liquidity</a> of the obligation;</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">embedded <a href="../articles/option.htm">options</a>; and</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">tax treatment of the obligation.</p> <p class="body">Current market interest rates are reflected by some benchmark <a href="../articles/fixed_income_term_structure.htm">yield curve</a> or spot curve. Since these are <a href="../articles/term_structure.htm">term structures</a>, they reflect the maturity dependence of interest rates. For <a href="../articles/currency_codes.htm">USD</a>-denominated instruments, <a href="../articles/treasury_securities.htm">Treasuries</a> are often used as a benchmark. The <a href="../articles/interest_rate_swap.htm">swap curve</a> is also used. </p> <p class="body">Contributions of other factors are modeled as <a href="../articles/yield.htm">yield</a> or interest rate <a href="../articles/spreads.htm">spreads</a> 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 <a href="../articles/spreads.htm">spread</a> for credit risk, plus a spread for liquidity, plus a spread for embedded options, etc. This is illustrated for a hypothetical <a href="../articles/callable_bond.htm">callable</a> <a href="../articles/corporate_bond.htm">corporate bond</a>. </p> <div align="center"> <center> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="350" cellpadding="0" id="table6"> <tr> <td> <p class="exhibit_header"><span class="exhibit_header">Example: Spreads</span><br> <span class="exhibit_subheader">Exhibit 1</span></td> </tr> <tr> <td bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td> <img border="0" src="../images/ex1_interest_rate_spreads.gif" width="349" height="185"></td> </tr> <tr> <td> <p class="exhibit_legend">The spot curve used for valuing a callable corporate bond might be modeled as the Libor/swap curve plus spreads for credit risk, liquidity and the optionality of the call feature.</td> </tr> </table> </center> </div> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="left" id="table7"> <tr> <td width="336" height="10"><font size="2"> </font></td> <td width="9" height="10"></td> </tr> <tr> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table> <p class="body">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.</p> <p class="body">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.</p> <p class="body">Spreads due to optionality arise with instruments such as callable bonds or <a href="../articles/mortgage_backed_security.htm">mortgage-backed securities</a> (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 <a href="../articles/option_adjusted_spread.htm">option-adjusted spread</a> analysis. </p> <p class="body">Many instruments do not have liquid secondary markets, and their prices are depressed for this reason. This is reflected in a <b> <a name="liquidity spread">liquidity spread</a></b>. Liquidity spreads are apparent in the secondary market for US Treasury securities. The most recently issued Treasuries are said to be <a href="../articles/treasury_securities.htm">on-the-run</a>. There is a liquid secondary market for on-the-run Treasuries. Other Treasuries are said to be <a href="../articles/treasury_securities.htm">off-the-run</a>, 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. </p> <div align="center"> <center> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="350" cellpadding="0" id="table8"> <tr> <td> <p class="exhibit_header"><span class="exhibit_header">US Treasury Yields to Maturity<br> November 16, 2000</span><br> <span class="exhibit_subheader">Exhibit 2</span></td> </tr> <tr> <td bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td> <img border="0" src="../images/ex2_interest_rate_spreads.gif" width="350" height="231"></td> </tr> <tr> <td> <p class="exhibit_legend">On November 16, 2000, 174 distinct Treasury securities (bills, notes and bonds) were trading. YTM is plotted 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 above the 5-, 10- and 30-year on-the-runs there are a smattering of off-the-runs trading at lower YTM's than others. These are the most recently issued off-the-runs whose liquidity spreads have not yet fully widened.</td> </tr> </table> </center> </div> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="165" align="left" id="table9"> <tr> <td width="160">  </td> <td width="11"> </td> </tr> <tr> <td width="160"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script> </td> <td width="11"> </td> </tr> </table> <p class="body">Note that liquidity spreads are distinct from <a href="../articles/spreads.htm">bid-ask spreads</a>. 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.</p> <p class="body"><b><a name="Credit spreads">Credit spreads</a></b> reflect the particular nature of an obligation. For example, secured 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.</p> <p class="body">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.</p> <p class="body"><b><a name="Tax spreads">Tax spreads</a></b> are generally negative spreads reflecting tax advantages of certain obligations. In the United States, income from most <a href="../articles/municipal_securities.htm">municipal bonds</a> 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 <i>et al</i> (<a href="#Elton (2001)">2001</a>) 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 <a href="../articles/corporate_bond.htm">corporates</a> are.</p> <p class="body">Another example of tax spreads is <b><a name="flower bonds"> flower bonds</a></b>. <span style="font-size: 12.0pt; font-family: Times New Roman">Between 1953 and 1963, the US Treasury issued a number of <a href="../articles/treasury_note_and_bond.htm">Treasury bonds</a> with a special feature. If tendered as payment of federal estate taxed, the bonds would be valued <a href="../articles/par_value.htm">at par</a>, irrespective of their current <a href="../articles/valuation.htm">market value</a>. 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 <a href="../articles/coupon_bond.htm">coupon</a> of 3.5% and matured in 1998.</span></p> <p class="body"><span style="font-family: Times New Roman">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 <a href="../articles/arbitrage.htm">arbitragers</a> to eliminate minor price discrepancies. Aguais et al. (<a href="#Aguais">1998</a>) 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.</span></p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table10"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table11"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/basis_swap.htm">basis swap</a> A floating-for-floating interest rate or currency swap.</strong></p> <p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/coupon_bond.htm">bond</a> Securitized debt.</p> <p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/corporate_bond.htm">corporate bond</a> A bond issued by a corporation.</strong></p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/compounding.htm">compounding</a> Simple, compound and continuously compound interest.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/fixed_income_term_structure.htm">fixed income term structure</a> Refers collectively to a spot curve, forward curve, discount curve, yield curve or any other curve that describes the time value of money at a particulate point in time.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/interest_rate_parity.htm">interest rate parity</a> An arbitrage condition that must hold between the spot interest rates of different currencies.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/interest_rate_risk.htm">interest rate risk</a> Risk due to uncertain future interest rates.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/option_adjusted_spread.htm">option-adjusted spread</a> Yield spread not attributable to embedded options.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/return.htm">return</a> Any of a number of metrics for the change in an asset's or portfolio's accumulated value.<p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/spread_risk.htm">spread risk</a> Risk due to exposure to some spread.</strong></p> <p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/treasury_securities.htm">Treasury security</a> US Federal Government debt obligation issued by the Department of Treasury.</p> </td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Books</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table12"> <tr> <td width="100%"> <p class="explanatory_text">Fabozzi (<a target="_blank" href="http://www.riskbook.com/link/fabozzi_frank_(2000).htm">2000</a>) is the standard reference on fixed income securities.</p> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table13"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap505"> <area target="_blank" href="http://www.riskbook.com/link/fabozzi_frank_(2000).htm" shape="rect" coords="0, 0, 83, 124"> </map> <img border="0" src="../images/book_fabozzi_f_(2000)_125.gif" usemap="#FPMap505" width="84" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table14"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/fabozzi_frank_(2000).htm"> Handbook of Fixed Income Securities</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Frank J. Fabozzi</b></td> </tr> <tr> <td width="10%"> <map name="FPMap503"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/star_5.gif" usemap="#FPMap503" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"><map name="FPMap504"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/tech_2.gif" usemap="#FPMap504" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">2005</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap452"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/fabozzi_frank_(2000).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap452" width="146" height="20"></td> </tr> </table> </td> </tr> </table> </td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Sponsored Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" width="75"> <img border="0" src="../images/ad_side_banner_2.jpg" width="103" height="285"></td> <td bgcolor="#FFFFCC" width="99%">  <p class="ad_legend" style="margin-left: 0; margin-bottom:2"> <a target="_top" href="http://www.riskexpertise.com/link/advertising.htm"> <font color="#000000">Ads by Contingency Analysis</font></a></p> <p style="margin-top: 0; margin-bottom: 0"> <iframe src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82436;type=iframe" style="margin: 0px; padding: 0px; border-width: 0px" width="336" height="265" frameborder="0" marginwidth="0" marginheight="0" scrolling="no" name="I1"> <![if lt IE 4]> <script src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82436;type=js" type="text/javascript"> </script> <noscript> <a href="http://servedbyadbutler.com/go2/;ID=147917;size=336x265;setID=82436"> <img src="http://servedbyadbutler.com/adserve.ibs/;ID=147917;size=336x265;setID=82436;type=img" border="0" height="265" width="336" alt=""></a> </noscript><![endif]></iframe>   </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Cited Papers</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table15"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_paper_glossary.gif" width="21" height="15"><a name="Aguais">Aguais</a>, S. D., L. Forest, S. Krishnamoorthy, and T. Mueller (1998). Creating value from both loan structure and price, <i>Commercial Lending Review</i>, 13 (2), 13-24.<p class="explanatory_text"> <img border="0" src="../images/bullet_paper_glossary.gif" width="21" height="15"><a name="Elton (2001)">Elton</a>, Edwin J., Martin J. Gruber, Deepak Agrawal and Christopher Mann (2001). Explaining the Rate Spread on Corporate Bonds, <i>Journal of Finance</i>, 56 (1), 247-277.</td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Forum Discussions</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table16"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_bullhorn_narrow.gif" align="left" width="27" height="22"><a target="_top" href="http://www.contingencyanalysis.com/archive/link_thread/06-2/00000406.htm">CDS spead correlation</a> <i>03 May 2006</i><br> Only 50% of a credit spread may be due to credit risk.<p class="explanatory_text"> <img border="0" src="../images/bullet_bullhorn_narrow.gif" align="left" width="27" height="22"><a target="_top" href="http://www.contingencyanalysis.com/archive/link_thread/99-3/000000e8.htm">interest rate for bad credit recovery</a> <i>04 Jun 1999</i><br> Brief exchange about what interest rate to discount the value of distressed debt.</td> </tr> </table> </td> </tr> </table> <p align="center" style="margin-top: 18"><map name="FPMap365"> <area target="_top" href="http://www.riskglossary.com" shape="rect" coords="0, 0, 164, 102"> </map><img border="0" src="../images/logo.jpg" usemap="#FPMap365" width="165" height="103"></p> <p align="center"><span class="verdana10"> <a href="http://www.riskglossary.com/main/disclaimer.htm" target="_self"> Disclaimer</a></span></p> <p align="center">website: <span class="verdana10"> <a target="_top" href="http://www.contingencyanalysis.com"> http://www.contingencyanalysis.com</a></span><br> glossary direct link: <span class="verdana10"> <a target="_top" href="http://www.riskglossary.com"> http://www.riskglossary.com</a></span><br> copyright © Contingency Analysis, 2005<p align="center"><map name="FPMap1"> <area target="_top" href="http://www.contingencyanalysis.com" shape="rect" coords="0, 0, 240, 88"> </map><img border="0" src="../images/logo_glossary_white.gif" usemap="#FPMap1" width="241" height="89"></td> <td>  </td> </tr> </table> </div> </body>