Corporate Bond / CDS / IRS
Hi,
I have a question on an example concerning interest rate swaps and CDS that is described in the book The New Lombard Street by Perry Mehrling, that can by the way be downloaded for free here: http://press.princeton.edu/class_use/courses/mehrling/
On page 80 the author tries to give a basic example of how IRS and CDS work. He assumes 3 parties, called Mr. Investor, Mr. Default and Mr. Interest. Mr. Investor holds a corporate bond and agrees with Mr. Default that the latter will give Mr. Investor the same payments that the U.S. Treasury makes on its bond (of the same maturity) in return for the payment of the corporate bond. Mehrling describes this as a CDS.
Here is my first question: Why would Mr. Investor not buy the Treasury bond himself, rather than make such a swap?
Then the example continues: Mr. Investor promises Mr. Interest (who holds a Treasury bill) to make fixed interest payments that the Treasury bond makes in return for the floating interest payment that the Treasury makes on a sequence of Treasury bills over the same horizon.
Now Mehrling says, "The important point is that, if all works as planned, these swaps leave Investor with the same risk exposure as if he were holding a short-term Treasury bill instead of a long-term corporate bond."
So here is my second question: Why would the author use this example when at the end it doesn't make any sense because the Investor would be in the same position as if he had bought the Treasury bill from the beginning. Or do I miss something?
Thanks!
1) Mr Investor could buy the UST himself, but a) UST bonds don't necessarily exist with the exact correct maturity (and other details); and b) UST bonds potentially have idiosyncrasies and issues which Mr Investor might not want to deal with. Thus, instead of buying the UST, with all the potential complications this entails, Mr Investor asks their friendly highway bandit, sorry, I meant investment bank, for a derivative.
2) The idea here is that a treasury bond and a treasury bill have significantly different maturities. Bills are short-dated instruments, whereas a bond is a long-dated instrument. So the overall idea is, after Mr Investor has first converted the corporate bond cashflows into US treasury bond cashflows, they then can convert US treasury bond cashflows (which are fixed for the life of the bond) into a set of floating US treasury bill cashflows.
Thank you Martinghoul for the quick answer.
Could you please be so kind and elaborate on the idiosyncrasies and other problems buying a UST could exhibit, especially compared to buying a corporate bond, as in my example.
I am also wondering why Mr. Investor does not swap the corporate bond with treasury bond rather than immediately with a treasury bill?
Thanks!
Well, there are all sorts of USTs out there. Some are high- or low-coupon bonds and trade at prices that are significantly different to par, which has all sorts of interesting effects (these effects may vary depending on mkt conditions). Then there's a question of repo, with some bonds trading "rich" or "expensive" vs some notion of "fair value" as a result of how easy they are to finance. Finally, individual govt bonds often have lives of their own, depending on liquidity, who owns them etc (maybe this isn't as much the case with a deeper, more liquid UST mkt, but it's present even there). To be sure, the point here isn't to compare the UST to the corporate bond. When you're a credit investor who buys/sells a corp bond, among other things, you're looking to express a view on the idiosyncratic features of this bond. You certainly wouldn't want to be required to have a view about the specific features of the corresponding UST.
As to why choose to do it with a bond, firstly, pls realize that the author is giving you this two-step explanation for clarity's sake. In reality, you can't very easily do the leg of the trade that's transacted between Mr Investor and Mr Interest using actual bonds and t-bills (well, maybe now you can, but let's not go into that). Reason is that, remember, Mr Investor needs to ultimately "exchange" their corp bond for a series of t-bills that are settled at regular intervals in the future, over the whole lifetime of the bond. That's why Mr Investor would use a combination of CDS and interest rate swap.
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