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

3 Issuing costs of state guaranteed bonds
Trade Reporting and Compliance Engine (TRACE) information was also considered for use in the
study but this was infeasible due to lack of data availability.
Exchange rate premia
SG and non-SG bonds considered in this study are denominated primarily in Euros. However, a fair
number of bonds are denominated in US Dollars, and a small but not inconsequential minority of
bonds is denominated in other currencies such as Pound Sterling, Swedish Krona, Danish Krone
and other currencies.
The choice of bond currency denomination is driven by exchange rate risk considerations, which
are reflected as premia (or discounts) to issuing costs. To reflect this, issuing costs are adjusted to
reflect Euro-domestic currency basis swap spreads, which are market-based measure of exchange
rate premia. This adjustment allows for better comparisons of bonds denominated in different
currencies.
Primary versus secondary market spreads
Primary market issuing cost measures are preferred to secondary market measures because they
more closely reflect issuing cost, discounting non-fundamental, secondary market factors. In
particular, bonds tend to be thinly traded further away from their issue dates, and therefore,
credit spreads are likely to reflect a degree of liquidity risk and other factors in addition to the
fundamentals of the bond issues.
Using primary spreads means collecting data on bonds at different points in time. This means, for
instance, we may observe different spreads for otherwise equivalent bonds due to different bond
market conditions at the times each was issued. To account for this time-variation, we include a
number of controls in our model of issuing costs, including time dummies and an index of market
sentiment, which are described in more detail in the section below.
Conclusion
For the purposes of this study, credit spreads are used as a measure of issuing cost.
We showed how issuing costs as returns to investors are the appropriate variable of interest,
exclusive of guarantee fees and other fees.
We then illustrated that credit spreads are useful in terms of capturing market expectations of
bank credit risk in a single statistic. Furthermore, policy questions can be addressed empirically
through isolating the impact of drivers of credit spreads (especially, the impact of state guarantees
on issuing cost).
Different measures of credit spreads were then considered and we settled on Z-spreads as the
preferred measure for the empirical analysis.
Pricing sources and the use of the CBBT as the main pricing source for the benchmark curve was
then discussed, followed by our approach for accounting for exchange rate premia in our measure
of issuing cost.
Finally, we covered our preference for and use of primary issuing cost data.
36