From Asset Swaps To Z Spreads
From Asset Swaps To Z Spreads
From Asset Swaps To Z Spreads
Cashflows CASH
• Example: as at 5th July, 5yr GBP interest rate swap is quoted at 2.44%
• Every 6 months, in arrears, Counterparty A pays 6m LIBOR on swap notional LIBOR legs cancel out leaving
• Every 6 months, in arrears, Counterparty B pays 2.44% (at annual rate) on swap notional Counterparty B receiving a fixed
• See slide 6 for details rate
1London Interbank Offered Rate – the average calculated at 11:00am each day using a trimmed arithmetic mean (i.e. average after dropping the top and bottom
quartiles), based on submissions from a panel of contributor banks 4
Asset Swaps to Z-spreads
Present Values and Discount Factors
40
This is also known as the “discount factor”
20
0
0 10
1Present value and discount factor calculations for bonds and swaps require detailed knowledge of day count and compounding conventions which is beyond the
scope of this presentation 5
Asset Swaps to Z-spreads
Interest Rate Swap Example
What is a Swap? Example: Cash Flows on a 5 year GBP Interest Rate Swap
Interest Rate Swap Cashflows
LIBOR payments - unknown
• All future cash flows on the fixed leg are known at inception
• LIBOR leg payments are unknown
• Forward LIBOR payments can be derived from the interest rate Fixed payments
swap curve (see page 9)
• Discount factors can also be derived for each payment date from
the swap curve (see page 9)
• BY DEFINITION, the present value of the fixed leg is equal to the
Periodic exchange of cash flows for life
present value of the floating leg at the time of the transaction of transaction
• Fixed rate weighted average of forward LIBOR rates over life of
swap
Example: 5year GBP Interest Rate Swap @ 2.44% Example: 5year GBP Interest Rate Swap @ 2.44%
Fixed Leg Floating Leg 2.0%
Discount Cash Present Cash Present 1.8%
Date 1.6%
Factor Flow Value Flow Value
1.4%
07 Jan 11 0.99486 1.23% 1.22% 0.52% 0.51% 1.2%
07 Jul 11 0.98896 1.21% 1.20% 0.60% 0.59% 1.0%
09 Jan 12 0.98153 1.24% 1.22% 0.76% 0.74%
0.8%
09 Jul 12 0.97235 1.22% 1.18% 0.94% 0.92%
0.6% Fixed Leg
07 Jan 13 0.96084 1.22% 1.17% 1.20% 1.15%
08 Jul 13 0.94771 1.22% 1.15% 1.38% 1.31% 0.4%
Floating Leg
07 Jan 14 0.93308 1.22% 1.14% 1.57% 1.46% 0.2%
07 Jul 14 0.91730 1.21% 1.11% 1.72% 1.58% 0.0%
07 Jan 15 0.90114 1.23% 1.11% 1.79% 1.62%
07 Jul 15 0.88439 1.21% 1.07% 1.89% 1.68%
Total 11.56% Total 11.56%
Source: Bloomberg, Redington Source: Bloomberg, Redington
6
Asset Swaps to Z-spreads
Introduction to Zero Coupon Swaps
• Any desired cash flow profile can be structured using zero coupon
Single exchange of cash flows at end of
swaps transaction
• Zero coupon swap curve is very useful tool for calculating present
value of any series of future cash flows
THE MATHS1
• A key advantage is that it takes account of the shape of the swap
curve and uses a term specific rate for each cash flow • Fixed Leg: (1 ZCswaprate) n
• The discount factor is derived from the zero coupon swap rate (see n
1For illustration of concepts only: actual calculations require detailed knowledge of day count and compounding conventions, which is beyond the scope of this presentation
7
Asset Swaps to Z-spreads
Discount Rates and Swap Curves
1
Asset Swaps to Z-spreads
Par/Par Asset Swap - Example
Z-spreads
We can now move on to the calculation of Z-spreads Zero Coupon Swap Curves
as at 5th July, 2010
4.5%
Definition
4.0%
• The Z-spread is a purely theoretical concept designed to
3.5%
allow a bond yield to be compared to a swap rate as fairly as
possible 3.0%
• The Z-spread is defined as the size of the shift in the zero 2.5%
coupon swap curve such that the present value of a bond’s 2.0%
0.0%
1.05
Z-Spread Calculation - 4% 5 year GBP bond at Par
Par Swap + Z- Discount Factor
Term Par Swap Rate Bond Cash Flow Present Value
spread (160.7bp) 1.00
DF ZC Swap +160.7
0.5 1.02% 2.63% 2.00% 1.97%
1.0 1.11% 2.72% 2.00% 1.95%
0.95
1.5 1.25% 2.85% 2.00% 1.92%
2.0 1.40% 3.01% 2.00% 1.88%
2.5 1.60% 3.21% 2.00% 1.85% 0.90
3.0 1.79% 3.41% 2.00% 1.81%
3.5 1.97% 3.60% 2.00% 1.77%
4.0 2.15% 3.79% 2.00% 1.72% 0.85
4.5 2.30% 3.94% 2.00% 1.68%
5.0 2.44% 4.09% 102.00% 83.45%
100.00% 0.80
Characteristics Counterparty B
• A zero coupon inflation swap is an agreement to exchange a
FIXED PAYMENT
INFLATION
fixed cash flow for an unknown cash flow equal to the change
in the RPI index over the period
Unknown cash flow
Comparison with index-linked bonds => known cash flow
• The direct comparison with index-linked gilts is less
straightforward than for an interest rate swap
Cashflows1
• Example: as at 5th July, 5yr GBP zero coupon inflation swap is
quoted at 3.20%
• After 5 years, Counterparty A pays the change in the RPI
index (= RPI5 /RPI0 ) on swap notional
• After 5 years, Counterparty B pays 3.20%, compounded for 5
years (=1.0325 = 127.7%) on swap notional THE MATHS1
• Fixed Leg: (1 ZCRPIswapraten ) n
Other forms of inflation swap
• There are other forms of inflation swap – for example with RPI n
annual inflation linked cash flows • Inflation Leg:
RPI 0
• The ZC swap is the most useful and common form
1For
illustration of concepts only: actual calculations require detailed knowledge of day count and compounding conventions, inflation index publication lags & seasonality
which is beyond the scope of this presentation 13
Asset Swaps to Z-spreads
Index-Linked Gilts
0.52%
ASSET SWAPPING INDEX-LINKED GILTS 0.50%
• In order to do an asset swap, we need to be able to swap a
0.48%
fixed rate (i.e. the coupon on a nominal bond) against a floating
rate 0.46%
• Therefore, asset swapping linkers is a two stage process: 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
o Swap inflation linked payments to fixed payments using Years
a series of zero-coupon inflation swaps, one for each Source: Redington – illustrative only
payment
o Swap the fixed payments for floating payments using
interest rate swaps
• The Z-spread is then defined as before – i.e. the parallel shift in
the ZC swap curve such that the present value of the fixed
payments derived above is equal to the dirty price of the bond
Spread (bps)
largest source of inflation to hedge inflation swaps 100
o issuance of inflation linked debt dried up due to issues
80
with monoline insurers who had wrapped much of this
60
debt
• Bank balance sheets rapidly delevered – since then, other drivers: 40
• Government bonds
o Investing in a government bond results in full credit exposure to the government for both coupons and principal
o In event of default or debt restructuring, coupon and principal payments will be impaired to varying degrees
16
Asset Swaps to Z-spreads
Corporate Bonds: Swap Spreads and Credit Spreads
• Exactly the same methodology can be used for corporate bond asset swap calculations Swap Counterparty
o Historically, this is where the bulk of asset swap market activity occurred
o The inversion of the relationship between government bonds and swaps resulted in a Fixed Rate LIBOR
Collateral
big pick up in activity in government bond asset swaps
Credit spreads Fund
• Traditionally:
o Credit spread = corporate bond yield – gilt yield Fixed
Coupons
• Corporates treasurers often swap fixed rate issuance back into floating rate, based on a funding
target of LIBOR +x% Corporate Bond
o Relative shape of swap curve and gilt curve drive issuance opportunities
• Gilt vs. swap spread a significant driver of gilt vs. corporate spread
CONCLUSION
Z-Spreads are Useful Theoretical Model to Enable Comparison of Relative Value of Corporate Bonds
17
Appendix
Overview of Alternative Asset Swap Methods
Asset Swaps to Z-spreads
Asset Swaps – Overview of Alternative Methods
Method Definition Yield Curve Directionality Simplicity Use for Relative Value
Exposure
Yield/Yield • Spread = difference between bond • Spread widens as • Convexity not hedged • The most simple • Good for flat curves
yield and same maturity swap rate curve steepens for – therefore hedge ratio ASW method • Poor for comparing bonds
• Duration weighted bonds above par needs adjusting on with very different coupons
large rate moves in steep curve environment
Par/Par • Spread added to floating leg such that • For given bond • Par/par spread falls as • Relatively complex • Spread highly dependent on
swap NPV = 100 – Bond dirty price price, par/par swap yields rise • Widely used, dirty price of bond therefore
• Bond bought for par spread falls as swaps • Trade not duration therefore good not idea l for RV use
• Swap fixed leg = bond coupons curve steepens neutral market familiarity
• Floating leg notional = bond notional
Market • Spread added to floating leg such that • For given bond • MVA spread rises as • Hard to estimate • Spread depends on dirty
Value swap NPV = 100 – Bond dirty price price, par/par swap yields rise P&L price of bonds – but not as
Accrued • Bond bought for dirty price spread falls as swaps • Trade not duration • Not frequently much as par/par, especially
or • Swap fixed leg = bond coupons curve steepens neutral trades for high coupon bonds
Proceeds • Floating leg notional = bond dirty price • Not widely traded, but
• Original dirty price – 100 paid to ASW preferred to par/par for RV
buyer at maturity calculations
Z - spread • Spread when applied to zero coupon • Some exposure to • Not directional • Straightforward to • Generally preferred for
swap curve such that when used to PV changes in relative calculate for most relative value use
bond cash flows, results in bond dirty steepness of risk systems
price government and
swap curves
Source: Morgan Stanley, “Using and Trading Asset Swaps”, 11 th May, 2006
1
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13-15 Mallow Street 7147
London EC1Y 8RD Telephone: +44 (0) 20 7250
3331
David Bennett
Director | Investment Consulting
[email protected]
www.redington.co.uk
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