Compare spread on a bond vs a loan/FRN?
I was discussing with a colleague, but in short, how do you compare a fixed bond vs a loan/frn when it comes to spread? Theoretically, you should get paid more for holding fixed bonds, as you have duration risk, so in my view you need to take the z spread of said fixed bond, substract the equivalent maturity swap rate, and compare the result vs the DM/zDM of the loan/FRN. Is this right?
Generally speaking, duration risk/considerations are left to PMs (to your point above, fixed rate debt has duration risk but floating rate debt has reinvestment risk, so it’s a wash) and analysts should focus on spread vs. discount margin and dollar prices
You're on the right track! When comparing the spread on a bond versus a loan or Floating Rate Note (FRN), there are indeed different factors to consider.
For a fixed bond, the spread is essentially the difference between the yield of the bond and the yield of a risk-free government bond of the same maturity. This spread compensates you for the additional risk you're taking on by holding the bond, including credit risk, liquidity risk, and as you rightly pointed out, duration risk.
On the other hand, the spread on a loan or FRN is typically over LIBOR or another reference rate. This spread compensates you for the credit risk of the borrower. However, because the interest rate on the loan or FRN is floating, you don't have the same duration risk as with a fixed bond.
So, when comparing the two, you're correct that you would need to consider the Z-spread of the fixed bond, which measures the spread over the entire Treasury yield curve, not just the equivalent maturity point. Subtracting the equivalent maturity swap rate would give you a measure of the credit risk premium on the bond.
Comparing this to the spread on the loan or FRN would give you a sense of the relative compensation for credit risk between the two instruments. However, keep in mind that this doesn't account for the duration risk in the fixed bond, which is not present in the loan or FRN.
So, in essence, you're correct! But remember, this is a simplified explanation and actual market dynamics can be much more complex.
Sources: Help Me Understand Fixed Income Investing, Q&A: Credit hedge fund analyst at MF, former BB trader, Math behind pricing a CMBS loan
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