Most fixed income products are traded on spreads. It's essential to know what this means.
Understanding Which Spread to Use
When talking about spread in fixed income, you are typically concerned with the Option Adjusted Spread (“OAS”). If you’re trading a corporate bond and someone says spread, they’re most likely talking about this type. OAS is similar to effective duration and effective convexity in that it takes a security's optionality into consideration. Essentially, the OAS runs a simulation of different interest rate paths to price out the security to the current market value. It then takes the average spread between all of the paths and applies that spread to discount the security back to the current market price. A simple example is if you have two paths, and the first spread is 500 and the second spread is 100 you will have an OAS spread of 300 (the average).
OAS is arguably the most important spread to consider and it's what the street monitors, however, most products are traded at nominal spread to the U.S. Treasury ("UST") curve. For MBS, you trade on a nominal spread above the interpolated UST curve and for corporates, you trade at a nominal spread above a similar maturity UST. (Note: trading on nominal spreads is a convention and you can just as easily trade on OAS or any other spread -- if you're ever confused ask which spread is being quoted.) If you are bidding a 10yr, investment-grade ("IG") corporate at 250// you are bidding 250bps above the current on the run 10yr UST. If you bid an MBS at +250 you are bidding a nominal spread above the interpolated UST curve.
Spreads are Additive to Rates
Now that you’re more familiar with spread, let’s return to the formula to price out a fixed income security. When pricing a security, each cash flow is discounted by the yield. Figure 1 shows the yield is made up of two components: rates and spreads.
The rates are usually the UST rate, which compensates an investor for inflation risk or the time value of money. It does not compensate the investor for corporate, default, downgrade, or any other risk. The compensation for these risks, are accounted for in the spread. As seen in Figure 2, the treasury rate combined with the spread will make up your total yield.
Total Yield = Rate + Spread
For example, if the 10yr UST is 4.00% and you buy a 10yr corporate bond at a 200bps spread over the 10yr UST you will be buying at a yield of 6%. Most fixed income products are considered “spread products” because they trade at a spread over a curve. If you ask for the price of an investment-grade, fixed-income corporate bond, you will typically get a quote in spread, for example +250 which is just 250bps above the reference UST security. You will also see “//” which is just a convention meaning “over the curve” or “to the curve”. A quote of +250 is the same as 250// which just means 250bps over the curve. Let’s price out an example: $1MM, 2yr maturity, 5% Coupon, Semi Annual, 250// and 2yr UST is 4%. Let’s visualize the price of this bond as seen in Figure 3:
You can see from Figure 3, that the price of the bond will be $97.23. The 400bps (4.00%) you get from the UST rate has nothing at all to do with corporate risk, downgrade risk, credit risk, market risk, anything except for a risk-free rate. You get compensated for all the risk, a side from pure interest rate risk, in the spread. The riskier the security, the larger the spread.
For example, the current average spread for investment grade corporates (BBB- or better) is about 200bps, where high-yield corporates are trading at a spread of 500bps or wider. The extra 300bps in spread, in this example, will compensate the investor for taking on additional risk.
Spreads & Maturity
It is important to know that the spread is over a similar maturity security. For example, a 10yr corporate bond will trade at a spread over the 10yr UST and a 30yr corporate bond will trade over a 30yr UST. For some securities, such as MBS, you match the weighted average life (“WAL”) of the MBS to an interpolated UST curve. The interpolated UST curve is just a linear interpolation between maturity points. An MBS with a WAL of 7.8yrs will trade at a 7.8yr linear interpolated point between the 7yr and 10yr on the run UST.
Spread Movement Can Help or Hurt
Rates and spreads could move in the same direction, or in opposite directions and you can gain or lose in any situation depending on which component moves the most. Figure 4 provides an example that show potential payoffs given rates and spreads in situations when they move together or in opposite directions. The bond in this example has a base case price of $84.17 (semi-annual payment, 5%, 5yr maturity bond).
You can see if positive correlation between rates and spreads holds up, there is significant upside potential when rates are lowered. Both spreads and rates would tighten and you win on both fronts and you go from $84.17 to $89.73.
How to Think About Price Movement
When trading spread products, you are only pricing in the spread, not the rate. If you’re trading an investment-grade corporate, or most spread products, you are getting bid/ask quotes in spreads, not rates, not price. Since you are trading on a spread, the underlying rate movement doesn’t really give you much information on the market or risk for the particular spread product, the spread does.
If you are looking at a bond today at a price of $84.17 (yield = 900; UST 400 + 500//) and then the price tomorrow moves to $82.41 (yield = 950; UST 450 + 500//), but rates moved up 50bps and spreads didn’t change, has the price of the security really changed? The answer is yes and no. The price of the security absolutely changed, the overall yield is now 950bps. The security is cheaper to buy, but the level or spread that the security is offered at didn’t change at all. This is very important to understand. As far as trading this security, the level is the exact same at 500//.
The reason the level hasn’t changed but price did is because we are looking at spreads. The spread is the same. The reason the price changed is because the yield has changed, and we are discount using yield. This might be a little confusing and that’s OK. Remember, spreads price in credit risk, not interest rate risk, and the credit risk didn’t change. Now the flip side of this coin, it we stick with this example and look at a bond with price $84.17 yield = 900; UST 400 + 500//, then the next day the price is $84.17 yield is 900 and rates tightened 50 bps to 350, but spreads widened out to 550//, you would say this bond is cheaper today than yesterday. That’s right, exact same price, but 50bps wider on spread. Remember, we’re trading on spread, not on price. Figure 5 illustrates these examples.
Hedging Rate Movement
Since we trade on spread, we are pricing in credit risk, not interest rate risk. To prevent a situation where interest rates move against you and deteriorate any value in your position, it’s very common to hedge out your interest rate risk i.e., rate movement using futures. For example, let’s say I’m long on a 10yr corporate bond and I only want spread exposure, i.e., credit risk exposure. To hedge out any interest rate risk, I would just short a 10yr treasury future of equal duration. This way I would have an off-setting position. If rates went up, then my bond would lose value, however, my hedge would gain value since I’m short a future. I would just continue to roll the position until I wanted to close out the hedge. I would typically close out the hedge when I no longer held the bond, or if I wanted full exposure to both interest rate and credit risk.
If you’re a buy-and-hold investor, then you might not hedge out your position. You would just buy the corporate bond and lock in the prevailing yield. Any gains or losses due to rate or spread movement would just be on paper.
Trading High Yield (“HY”) Corporates
To throw one more big curve ball, High Yield isn’t generally traded on spread, it’s traded on price! I know, mind blown. This is because HY has so much credit risk, it trades more like an equity. You still need to pay attention to high yield spreads, they are always talked about and important to follow; however, as far as making a market, you will typically see HY in price.
Trading on price theoretically mitigates some of the impact of duration. Recall that duration is interest rate sensitivity or risk. As previously stated, a fixed-income security is priced using a discounted cash flow. If you trade on spread, any movement in interest rate will impact the price of the security since it’s a direct input to your denominator used to discount your cash flow. However, if you trade on price and not on spread, then you are not so concerned with interest rate movement. Now there is a pretty big debate in the HY world about duration and whether it is as important to HY bonds as it is to IG bonds. I tend to lean toward the camp that thinks duration is still very important, but not as important in HY as it is in IG. That this is such a big debate just goes to show you spread is still extremely important in HY.
The above contains a lot of information on spreads, rates, duration, and trading on spread. Please let me know if you have any questions and I would be happy to elaborate or write an entire article on any particular section --Thank you for reading!