SPONSOR’S STATEMENT

CREDIT DERIVATIVES

Bond spreads as a proxy

for credit default swap spreads
Mark Davies and Dmitry Pugachevsky of Bear, Stearns & Company analyse
the use of bond spreads and how they relate to credit default swap spreads

The I spread S I is a discounting spread and is the shift required in Y to solve

T
here are several ways of looking at the credit spreads implied by bond
prices and there is often some debate as to which represents the best for the market price M, that is to say:
proxy for a credit default swap (CDS) spread. In this article, we look n
1 1
at the most commonly used spreads, discuss the situations in which they M = C ⋅∑ i
+ (3)
i =1 (1 + Y + S I ) (1 + Y + S I )n
differ and suggest which spread is the best proxy for a CDS spread.
Analysis of this kind is especially important in a steep yield curve envi- Z spread
ronment and where bonds are trading at a significant premium or discount The Z spread is another discounting spread and its calculation is similar to
to par. The most commonly used bond spreads available on Bloomberg are that of the I spread except that the Z spread is a shift of the whole riskless
the asset swap (AS) spread, the I spread and the Z spread. For the sake of zero curve necessary to solve for the market price M. Let us denote zero
simplicity we refer throughout to annual 30/360 (unadjusted) yields and rates corresponding to the bond payment dates as Z1, Z2,...Zn, then the
spreads and we assume that all bonds trades will settle on a coupon date expression for the riskless price is:
so there is no difference between clean and dirty prices.
n
1 1
Asset swap spread R = C⋅∑ i
+ (4)
i =1 (1 + Z i ) (1 + Z n ) n
An asset swap is the term used to describe a trade where the bondholder buys
a package consisting of a bond priced at par and a swap where the bond-
holder pays the bond coupon in exchange for Libor plus the AS spread SAS. and the Z spread is defined as the constant shift in each zero rate such that
Consider a risky bond with a notional of one and a market price M that is discounting the bond cashflows at the zero rate plus the Z spread Sz gives
lower than the riskless price R. The AS spread, when paid as an annuity, the market price M:
compensates the bond holder for the difference between the riskless price
n
1 1
and the market price: M = C ⋅∑ + (5)
i =1 (1 + Z i + S Z )i (1 + Z n + S Z ) n
R−M
S AS = (1)
RD
Note that when the bond has no embedded options, the Z spread is equal
where RD is the sensitivity of the riskless price to a change in the bond coupon. to the option-adjusted spread (OAS), which is quoted on Bloomberg.

I Spread Relationship between AS, I and Z spreads for a flat curve

Consider a bond that pays a coupon C annually and denote its riskless yield When the annual input rates on the yield curve are flat, these will be equal to
as Y. We can express the riskless price R as being the sum of the cashflows the annual zero rates and therefore equations 3 and 5 above are equivalent
discounted at Y, that is to say: and thus the I and Z spreads are identical:
n
1 1
R = C⋅∑ i
+ (2) SI = S Z (6)
i =1 (1 + Y ) (1 + Y )n
However, unless the bond is at par, the AS spread will not be the same as
the I or Z spreads. For a premium bond the AS spread is greater than the I
and Z spreads:
S AS > S I = S Z (7)
whereas for a discount bond the AS spread is less than the I and Z spreads:
S AS < S I = S Z (8)
To explain this, consider either the I or the Z spread since the analysis is the
same for both. So for the I spread, since the cashflows are discounted at yield
Y plus I spread as in equation 3, and since curve is flat, Y is equal to Libor, and
a bond that pays a coupon of Libor plus the I spread will be worth par. In the
event of default the coupon of Libor plus the I spread is no longer paid.
To replicate this for a bond with an arbitrary coupon we must introduce a
swap of this coupon with Libor plus I spread. But for this strategy to be iden-
tical to the floater above that pays Libor plus I spread, the swap must be
credit-linked such that it terminates in the event of a default. This credit link-
age of the swap is the crucial difference to an AS described above where the
cashflows on the swap continue even after a default.
Analysis of this kind is
important in a steep yield
coupon and note that MD will always be lower than RD.
Relationship between AS, I and Z spreads for an upward
sloping curve
When the riskless curve is upward sloping, zero rates increase with time and
the riskless yield Y will be bound by the first and the last zero rate:
Z1 < Z 2 < ... < Z n Z1 < Y < Z n (10)
To determine whether the I spread or the Z spread should be higher under
this scenario, let us consider the sensitivity of the bond price R in equa-
tion 2 to a shift of the I curve, which is made of a flat yield Y, versus the
sensitivity of R in equation 4 to a shift in the Z curve, which is composed
of the increasing zero rates. This sensitivity is the dollar duration, and
when this sensitivity is divided by the bond price R it is the modified dura-
tion, which is effectively a weighted average payment time, where the
weights are the discounted cashflows. The largest cashflow is the repay-
ment of principal and interest at maturity and in the Z calculation, this
cashflow is discounted using the rate which, as we have seen above, is
greater than Y. Thus the weight of this largest term is smaller, which
results in a lower sensitivity for the Z curve. To compensate for the same
difference between the riskless and the market prices, the Z spread must
be higher than the I spread.
SI < SZ
(11)

curve environment
Thus for a premium bond, where by definition the coupon must be greater
than Libor plus the I spread, the swap where the bond holder is paying the
coupon and receiving Libor plus the I spread will have a negative value when
taken in isolation, such as after a default. Thus to compensate the bond-
holder for the additional risk of having a swap that does not terminate on
default, the AS spread must be higher than the I or Z spread. The opposite
is true for a discount bond.
This difference can be expressed as:
1 1
S AS − S Z = ( M − 1) ⋅ ( − )
MD RD
where MD is the sensitivity of the market price to a change in the bond
It also can be shown for a par bond that under this scenario the AS
spread is lower then the I spread. To demonstrate this, consider the swap
that forms part of the asset swap package where the bondholder
exchanges the coupon for Libor plus the AS spread. The upward sloping
yield curve implies that the forward Libor rates will increase over time and
therefore if there is a default at some future point, this swap will have a
positive value because the average of the remaining libor payments will be
higher than the average of all the libor payments at the inception of the
swap. Since the credit-linked swap (described in the flat curve analysis
above) of Libor plus I spread does not continue to get paid post default,
the asset swap spread will be lower to take into account this potential
(9) future positive value of the swap.
Thus for an upward sloping curve and a par bond, the relationship
between spreads is:

Values of AS, I, Z and CDS spreads at different market prices

115 110 105 100 95 90 85 80

Approximation 0.50% 1.10% 1.77% 2.51% 3.33% 4.27% 5.34% 6.60%
CDS Spread 0.51% 1.13% 1.80% 2.56% 3.40% 4.35% 5.44% 6.73%
Z spread 0.52% 1.13% 1.78% 2.47% 3.21% 4.00% 4.85% 5.77%
I spread 0.51% 1.12% 1.76% 2.44% 3.17% 3.94% 4.78% 5.68%
AS spread 0.54% 1.15% 1.76% 2.36% 2.97% 3.58% 4.19% 4.80%
 SPONSOR’S STATEMENT

S AS < S I < S Z
(12)
Similarly, for a downward sloping yield curve – that is to say, zero rates
decrease with time – and a par bond:
S AS > S I > S Z (13)
CDS spread
For the analysis that follows, we assume for the sake of simplicity that there
is no basis between cash and derivatives and that the riskless curve is flat.
Consider a bondholder who owns a floater valued at par. As per the flat
curve analysis above, for a par bond the AS, I and Z spreads are all equal. If this
bondholder wishes to hedge this floater by buying credit protection in the form
of a CDS, for this strategy to be arbitrage free, the CDS spread must equal all
the other spreads:
S =S =S =S
AS I Z CDS
(14)
For a non-par bond these spreads will not be equal so we must now con-
sider which of the bond spreads is the best proxy for a CDS spread.
Consider a par bond and a discount bond that have the same maturity
and are issued by the same entity. Under this scenario the risk of default and
therefore the CDS spread is identical for both. If we assume that the bond-
holder's strategy is to buy just enough credit protection through a CDS to
hedge the credit exposure of the bond, therefore the amount of protection
needed for a bond trading at a discount will be less than par. Since the dif-
ference in the cost of protection between the par and discount bonds should
be reflected in the Z spread otherwise there would be an arbitrage, the Z
spread for a discount bond will be less than the Z spread for a par bond,
which equals the CDS spread. We can therefore expand expression (8) to get:
(17)
Re cov⋅ (1 / M − 1) ⋅ Conv
SCDS ≈ S Z ⋅ [1 + ]
(1 − Recov) ⋅ 2 ⋅ ModDur 2
The difference between the spreads increases with a bigger recovery and a
bigger discount or premium of the bond. Recovery does matter since the
recovery on a bond will be a percentage of the face value of the bond irre-
spective of the price at which the bond was purchased, whereas for a CDS
contract the recovery is a percentage of the face value of the contract, which
will match the market price of the bond at the time the strategy is executed.
Test results
Let us consider a 10-year bond that pays a 7% coupon semiannually with a
30/360 daycount basis, and assume that recovery is 40%. The table and
graph give the values of the AS, I, Z and CDS spreads, and an approxima-
tion from equation (17) for different market prices for the US swap curve from
September 18, 2003 (10-year swap rate = 4.64%).
It can be seen that throughout the whole range of prices, the Z and the
I spreads stay close to each other, and that the Z spread is closer to the
CDS spread than the AS spread. But for big discounts and premiums even
the Z spread is not a good enough proxy, and thus the adjustment in the
form of the formula (17) is necessary. Note that all yields and spreads are
also calculated based on semi-annual frequency and a 30/360 basis. ■
1
See Bear, Stearns & Company's working paper Comparison of Risky Bond Spreads
Spreads vs. Market Price
7.00%

6.00%
S AS < S I = S Z < SCDS (15)
5.00%
Approximation
Conversely for a premium bond:
Spread

4.00% CDS spread

Z spread
3.00%
S AS > S I = S Z > SCDS (16) I spread
AS spread
2.00%
It follows from both these expressions that in a flat curve either the I or the Z 1.00%
spread is a better proxy to the CDS spread than the AS spread.
0.00%
In a steepening curve, however, the Z spread is a better approximation to
80 90 100 110 120
the CDS spread, although it is possible to find examples of premium bonds Bond price
where the AS spread or I spreads are actually closer to the CDS spread, but
even in these cases the Z spread is very close to the CDS spread. Therefore
CONTACTS
the best overall proxy, without making any adjustments, for the CDS spread
is the Z spread. Mark Davies
There is a relatively simple adjustment to the Z spread to obtain an Tel: +1 212 272 0400
almost exact value for the implied CDS spread. It is possible to derive a for- e-mail: mdavies@bear.com
mula1, which only uses data quoted by Bloomberg such as modified dura- Dmitry Pugachevsky
tion and convexity and a single assumption for recovery. This formula can Tel: +1 212 272 2883
be easily applied: e-mail: dpugachevsky@bear.com