How does this framework actually help a manager value a credit product ? Can anyone help ?
Swap rate is usually a reference rate. Spread helps in identifying the difference between treasury rate (risk- free) and reference rate
Just to clarify because I’m thinking of comparable valuations as in equity with P/E etc… In other words as a bond manager we look to the current reference swap spread in the market ( for comparable time horizon and bond quality) to benchmark our portfolio held bond return and check whether it is under or over current market valuations ? Is that how this is used in practice ?
In practice, bonds are still traded/quoted as a spread to Treasuries but practitioners use swap spreads as one valuation method. For instance, dealer A might offer: $2MM BAC 4.90% 5/1/13 @ + 175/3s This means the dealer is offering the bonds at a yield of +175 bps to the benchmark Treasury. The benchmark Treasury is the three year, which has a yield of 1.41% so the ask yield is 1.41% + 1.75% = 3.16% Bonds are traded in spreads rather than absolute yield for a few reasons - 1.) The incremental yield above Treasuries and the risk with that trade is what the PM is really buying. He isn’t concerned with the absolute level or rates but rather how much more than a risk free asset he is yielding and whether he is being fairly compensated. 2.) Corporate bond interest rate volatility can be hedged using a multitude of instruments. Why interest rate swaps as a benchmark? I think examples are easiest. Let’s say the dealer offers these two bonds to the client: BAC 4.90% 5/1/13 @ + 175/3s BAC 0% 5/1/13 @ DM + 145/bps The top bond is a fixed rate bond offered at a yield of 1.75% + 3 year Treasury. The bottom is a floating rate bond offered at LIBOR + 135 bps. Let’s say he wants a fixed rate note. Which should he buy? With interest rate swaps, the trader can swap the floating rate for fixed, and end up with fixed rate reciever swap + 145 bps. To compare to the fixed rate bond, we should convert to a spread over swaps. Looking up the rate on the swap curve we find that the bonds yield relative to swaps is only +130. The trader can pick up 5 bps by buying the floater and swaping to fixed. Also consider the reverse, a bank that is borrowing LIBOR to fund a bond purchase. Are they concerned with the swap spread or the spread over Ts? Swaps. In theory they could swap out of fixed into floating and earn the spread.