Assume that an investor holds a bond and enters into an asset swap with a bank in which the investor pays the fixed coupon and receives Libor + spread
10y bond price 103, bond cpn 5.5%, 10y IRS rate 5%
The asset swap spread has 2 components:
- The excess value of the bond coupon over the swap rate is paid to the investor (only this if bond trades at par) 5.5 - 5.0 = 0.5%
- The difference between the bond price and par value is spread over the term of the swap, given the bond trades above par it will be some negative number and will be paid by the investor to the bank, say -0.1%
total asset swap spread = 0.5 - 0.1 = 4.9%
can you please explain, in the simplest possibile way, why if the bond trades above par the investor pays the second component to the bank and if it would trade below par the opposite applies?
