What the heck is an asset swap spread?

An asset swap spread is extra money paid when swapping a risky bond. It’s spent on top of the average floating rate. The floating rate is what banks charge each other for loans. This benchmark rate is called the interbank market rate.

The extra money, called the spread, compensates for the bond’s riskiness. Riskier bonds have higher spreads, while less risky bonds have lower spreads. The spread represents the bond’s credit risk above the interbank rate.

Floating coupons and risky bonds

In an asset swap, a risky bond is swapped for a floating-rate bond. The floating-rate bond pays a floating coupon, which is the interest paid on a bond. The coupon “floats” because it changes based on the benchmark rate.

The risky bond is dicey. It might not pay back all the money owed. This is called credit risk. To compensate for this risk, the floating coupon includes an extra payment. This extra bit is the asset swap spread.

Spreads show how risky a bond is

The spread tells you how risky the market thinks a bond is. The higher the spread, the more dangerous the bond. If a bond has a high chance of default, it will have a high spread. Default is when the bond issuer doesn’t pay back the money owed.

Investment-grade bonds have lower spreads. They are issued by stable companies and governments and are less likely to default. Junk bonds have higher spreads. They are more likely to go belly-up.

Basis points measure spreads.

Spreads are measured in basis points. A basis point is 0.01%. So 100 basis points equals 1%. A spread of 250 basis points means 2.5% paid on top of the interbank rate.

For example, say the interbank rate is 2%. A bond with a 250 basis point spread would pay 4.5%. That’s the 2% benchmark rate plus the 2.5% spread. The extra 2.5% compensates for the credit risk.

What makes spreads go up and down?

Spreads can change over time. They go up when a bond gets riskier. They go down when a bond gets safer. Spreads often rise in a lousy economy. More companies struggle to pay their debts in a recession. This makes their bonds riskier.

Rising spreads can be a warning sign. They show the market is getting worried. Falling spreads mean the market is more confident. It sees less risk on the horizon.

Following spreads in different markets

You can track spreads in different bond markets. The investment-grade corporate bond market will have different spreads than the junk bond market. Spreads also differ by country and region.

Emerging market bonds usually have higher spreads. These countries are seen as riskier, and they may have unstable economies or political systems.

Developed-market bonds have lower spreads. These countries are more stable and less likely to have a financial crisis or default on their debt. However, spreads can still jump in a global downturn.

How asset swap spreads work

Here’s the nitty-gritty on how asset swap spreads work. First, you need to understand floating rates. These are interest rates that change based on a benchmark. The most common benchmark is LIBOR. That stands for the London Interbank Offered Rate.

LIBOR is the average rate at which big banks charge each other for loans. It changes daily. Most floating rate bonds pay a coupon based on LIBOR. For example, a bond might pay LIBOR plus 100 basis points (1%).

Swapping for a floating rate

You trade a risky regular bond for a floating rate bond in an asset swap. The floating rate bond pays LIBOR plus a spread. The spread is the asset swap spread. It represents the credit risk of the original bond.

Here’s an example: Let’s say you have a corporate bond with a 6% coupon. You swap this bond for a floating-rate bond. The floating-rate bond pays LIBOR plus a spread.

If LIBOR is 2% and the spread is 250 basis points, the floating coupon would be 4.5%. That’s LIBOR (2%) plus the asset swap spread (2.5%).

The asset swap spread stays the same for the life of the bond. But the actual coupon payments will change. They rise and fall with LIBOR. If LIBOR goes up to 3%, the coupon would be 5.5% (3% + 2.5% spread).

Pricing credit risk

The 250-basis-point spread represents the credit risk of the original corporate bond—the extra yield you get for taking on that risk.

If the bond becomes riskier, the spread will go up. The market will demand more yield for the added risk. If the bond becomes safer, the spread will fall. The market will accept a lower yield for less risk.