3 Issuing costs of state guaranteed bonds - Financial Risk and ...

3 Issuing costs of state guaranteed bonds
years whereas it was three years in the case of the Barclays Bank SG bond issue. Thirdly, the state
guarantor for the Swedbank SG bond issue was the government of Sweden and for the Barclays
Bank SG bond issue was the UK government, whose sovereign risk may be valued differently.
These factors and a number of additional factors are discussed in section 3.2.2.
Measurement
As mentioned above, the key benefit of using a credit spread to measure issuing cost is that it
allows for the relative value of different securities to be compared within and across banks
through a single statistic.
In practical terms defining such a credit spread is challenging. There are trade-offs to consider,
particularly in the choice of a comparable benchmark. And, due to choices made in relation to
these trade-offs, there are a range of credit spread measures available, as described below. 7
Yield spread
The price of a bond, A, is equal to the present value of its payments (coupon plus principal) as
described by the equation below. The discount rate, yd, which balances the equation below, is its
yield-to-maturity.
P
P full is full (including accrued) price of the bond, Cd is the annualised coupon, fd is the coupon
frequency, yd is the yield-to-maturity and T1,…,TN is the time of each of the cashflow payments in
years.
The difference between the yield-to-maturity of the bond and the yield-to-maturity of the chosen
benchmark bond is known as the yield spread. The yield spread is applicable to fixed rate bonds
and the discount margin is the analogue measure that is applicable to floating rate bonds.
There are several problems with the yield spread. Firstly, the benchmark bond may not have the
same maturity as bond A (maturity mismatch). In the case where the benchmark bond matures
after bond A, the yield spread is normally likely to be underestimated. This is because the
(relatively) long-dated benchmark bond contains more liquidity risk than the (relatively) shortdated
bond A.
Secondly, the yield-to-maturity calculation assumes that interim payments in the form of coupons
can be reinvested at the same rate as the yield-to-maturity. 8 In most cases, this is likely to lead to
an overestimate of the yield-to-maturity because the credit quality of the issuing bank is likely to
change over time and returns on reinvestment may be closer to/further away from the benchmark
bond, at least for short periods of time.
7
See O' Kane and Sen (2004) for further details.
8
See Kelleher and MacCormack (2004) for an excellent discussion of the issues of yield-to-maturity (or internal rate of return)
calculations.
32
full
Cd
/ f
=
( 1+
y
d
fdT1
d )
Cd
/ f
+
( 1+
y
d
f T
d )
d 2
C / f
+ ... +
( 1+
d d
fdTN
yd
)
(1)