I spread

What Is I-spread?

The I-spread, also known as the interpolated spread, is a measure used in fixed income analysis to quantify the yield premium of a bond over a specific reference rate. It represents the difference between a bond's yield to maturity and the linearly interpolated yield of an appropriate interest rate swaps curve for the same effective maturity. The I-spread helps investors assess the additional return they receive for holding a particular bond compared to the risk profile reflected by the swap market, which includes a component for bank credit risk.

The I-spread is a crucial tool in bond valuation and for comparing the relative value of different debt instruments. It provides insight into the market's perception of a bond's risk beyond the inherent interest rate risk.

History and Origin

The concept of using spreads to compare bond yields has been present in financial markets for a long time, evolving alongside the complexity of debt instruments and benchmarks. The advent and growth of the interest rate swaps market, particularly since the early 1980s, provided a new, robust reference curve for spread analysis. The first publicly known swap agreement occurred in 1981 between IBM and the World Bank, aiming to manage currency and interest rate exposures. This landmark transaction helped catalyze the growth of the global swap market, which quickly became an essential tool for hedging and speculative purposes in over-the-counter (OTC) markets.⁶

As the swap market gained liquidity and provided a wide array of maturities, the swap curve emerged as a preferred benchmark for pricing various financial instruments, including corporate bonds.⁵ This led to the development and widespread adoption of the I-spread as an alternative to government bond benchmarks, particularly given potential distortions in government bond yields due to supply-demand dynamics or varying tax treatments.

Key Takeaways

• The I-spread measures the difference between a bond's yield to maturity and a corresponding interpolated swap rate.
• It serves as a key metric in assessing the credit component of a bond's yield.
• The I-spread is widely used for comparative bond valuation and identifying relative value opportunities in the fixed income market.
• Unlike spreads over government bonds, the I-spread reflects the credit quality of major banks that are active in the swap market.
• Its calculation requires the interpolation of the swap yield curve to match the bond's exact maturity.

Formula and Calculation

The I-spread is calculated as the difference between a bond's yield to maturity (YTM) and the interpolated swap rate for the same maturity.

Where:

• Bond YTM: The yield to maturity of the specific bond being analyzed. This represents the total return an investor can expect if they hold the bond until it matures, assuming all payments are made as scheduled.
• Interpolated Swap Rate: The yield of an interest rate swaps contract with a maturity that exactly matches the bond's maturity. Since swap rates are typically available for standard maturities (e.g., 1-year, 2-year, 5-year), linear interpolation is often used to determine the rate for non-standard maturities.

For example, if a bond matures in 4.5 years, and the 4-year swap rate is 3.00% and the 5-year swap rate is 3.50%, the interpolated swap rate would be:

If the bond's yield to maturity is 4.00%, then the I-spread would be:

Interpreting the I-spread

The I-spread provides insight into how the market perceives a bond's credit risk relative to the default risk of the financial institutions that underpin the swap market. A positive I-spread indicates that the bond offers a higher yield than a comparable swap, implying that investors require additional compensation for holding that bond. This compensation typically reflects the bond issuer's perceived creditworthiness and other factors like liquidity.

A widening I-spread can signal an increase in the market's perception of the bond issuer's risk, or potentially a decrease in the liquidity of that specific bond. Conversely, a narrowing I-spread suggests improving credit quality or increased demand for the bond. Portfolio managers and traders use the I-spread to identify undervalued or overvalued bonds, helping them make informed decisions regarding their fixed income portfolios.

Hypothetical Example

Consider a newly issued corporate bond with a 7-year maturity and a yield to maturity of 5.80%. To calculate its I-spread, an analyst would look at the prevailing swap rates. Assume the 7-year swap rate is 4.50%.

1. Identify the Bond's YTM: The bond's YTM is 5.80%.
2. Find the Relevant Swap Rate: The 7-year swap rate is 4.50%. (No interpolation is needed here as the maturity is a standard swap tenor).
3. Calculate the I-spread:
   I-spread = Bond YTM - Swap Rate
   I-spread = 5.80% - 4.50% = 1.30% or 130 basis points.

This 130 basis point I-spread suggests that investors are demanding an extra 1.30% yield to hold this particular corporate bond compared to the rate offered by a 7-year interest rate swap, reflecting the additional credit risk of the corporate issuer beyond the implied risk of the swap counterparty.

Practical Applications

The I-spread is a widely used metric in professional fixed income markets for several reasons:

• Relative Value Analysis: Investors frequently use the I-spread to compare the relative attractiveness of different corporate bonds across various sectors and credit ratings. A higher I-spread for a given credit rating might suggest a better risk-adjusted return, assuming all other factors are equal.
• Bond Pricing and Issuance: For new bond issuances, the I-spread helps underwriters and issuers determine appropriate pricing. The I-spread provides a common reference point that accounts for broader market interest rate swaps and a component of the issuer's credit quality.⁴
• Hedging Strategies: Fixed income portfolio managers often use interest rate swaps to hedge interest rate risk. The I-spread can help in identifying mispricings between bonds and swaps, which can be exploited through arbitrage or hedging strategies.
• Credit Analysis: While not a pure measure of default risk, movements in the I-spread can provide signals about changes in market sentiment regarding an issuer's creditworthiness.
• Market Benchmarking: The swap curve, underlying the I-spread, serves as a more stable and liquid benchmark than government bond curves in some jurisdictions, especially for longer maturities or in markets where government bond supply can be erratic.³

Limitations and Criticisms

Despite its utility, the I-spread has certain limitations and criticisms:

• Not a Pure Credit Spread: The I-spread is not solely a measure of an issuer's credit risk. The swap rate itself contains elements of bank credit risk (specifically, the collective credit risk of the large financial institutions that act as market makers in the swap market). Therefore, the I-spread reflects the bond's credit risk relative to this bank credit risk, not necessarily an absolute measure of the bond's default probability.²
• Liquidity Premiums: The I-spread can also encompass a bond's liquidity premium. Less liquid bonds may trade at a wider I-spread simply due to their lower tradability, rather than solely reflecting higher credit risk.
• Interpolation Accuracy: The accuracy of the interpolated swap rate depends on the interpolation method used and the availability of granular swap rate data. Linear interpolation, while common, might not always perfectly reflect the true shape of the yield curve, especially in volatile markets or at the extremes of the maturity spectrum.
• Market Dynamics: Supply and demand dynamics in the swap market, as well as regulatory changes, can influence swap rates, which in turn affect the I-spread. These factors may not directly relate to the bond issuer's fundamental credit quality.
• Embedded Options: The I-spread, in its basic form, is best suited for "plain vanilla" bonds without embedded options (e.g., callable or putable bonds). For bonds with such features, other spread measures like the Option-Adjusted Spread (OAS) are typically more appropriate, as they account for the value of these options.¹

I-spread vs. G-spread

The I-spread and G-spread are both measures of credit spread, but they differ in their choice of benchmark curve. The I-spread uses the interpolated interest rate swaps curve as its reference, whereas the G-spread uses an interpolated government bond yield curve.

The key distinction arises from the characteristics of their respective benchmarks. Government bond yields are often considered "risk-free" in the context of default risk for that sovereign entity, but they can be influenced by specific supply-demand factors, tax treatment, and flight-to-quality flows. The swap curve, on the other hand, reflects the collective credit risk of the major financial institutions that constitute the over-the-counter swap market. As such, the swap curve is often viewed as a more consistent and liquid benchmark for assessing corporate credit risk, as it's less affected by sovereign-specific issuance patterns or unusual demand for government debt. However, because the swap curve incorporates a component of bank credit risk, the I-spread includes this element, which is typically absent in a G-spread.

FAQs

What does a negative I-spread mean?

A negative I-spread means that the bond's yield to maturity is lower than the interpolated swap rate for the same maturity. This is uncommon for most corporate bonds because they typically carry higher credit risk than the implied bank risk in swap rates. A negative I-spread could suggest that the bond is significantly overvalued, has unique tax advantages, or benefits from extremely high liquidity or a "safe haven" premium.

Is the I-spread a good measure of credit risk?

The I-spread provides a useful indication of credit risk relative to the swap market. However, it's not a pure measure of an issuer's default risk because the underlying swap rate itself contains a component of bank credit risk. It's best used in conjunction with other credit analysis tools and spread measures.

How does the I-spread relate to the swap curve?

The I-spread directly uses the swap curve as its benchmark. The swap curve plots swap rates across different maturities, providing a baseline for calculating the I-spread. The I-spread measures how much more yield a specific bond offers compared to the equivalent point on that swap curve.

Can the I-spread be used for bond portfolio management?

Yes, the I-spread is a valuable tool for bond portfolio management. It helps portfolio managers compare bonds, identify relative value opportunities, and make decisions about sector allocation and credit exposure. By analyzing changes in I-spreads, managers can assess shifts in market perception of credit risk and adjust their holdings accordingly.

What is the difference between a fixed rate and a floating rate in the context of swaps?

In an interest rate swaps agreement, one party typically pays a fixed rate of interest on a notional principal, while the other party pays a floating rate of interest on the same notional principal. The I-spread uses the fixed leg of the swap as its reference, as this rate is comparable to the fixed yield of a bond.