Why swap spreads are a good proxy for credit spreads?
The swap spread is a more pure form of lending/borrowing in a free market. There is little government interference, no one but the willing parties set their rates.
You could analyze a swap, let’s say at 4.5% fixed for 7-years and compare that rate to the rate of a 7-year treasury note that yields 3%. You could say that the market ‘spread’ is 4.5% less the ‘risk-free’ rate of 3%. The credit spread is therefore for 1.5%
Why is there government interference on credit spreads? Isn’t it just about taking the difference between the yield on a bond and the yield on a treasury bond with same maturity? And the swap spread, the difference between the swap rate and the yield on a treasury bond with same maturity as well? There are several discussions currently ongoing on the forum about this but i really don’t get it :-/
The government can manipulate the Treasury yield, which will manipulate the spread.
^ but that would manipulate the swap spread as well!
Not if the floating rate for the swap spread it LIBOR.
But everywhere i searched for a definition of the swap spread, they compute it based on treasury, not on the libor rate mentioned in the contract itself. Could it be that there are different practices on this? Thanks
No issue of different practices.
Look at Galli’s example - “You could analyze a swap, let’s say at 4.5% fixed for 7-years and compare that rate to the rate of a 7-year treasury note that yields 3%. You could say that the market ‘spread’ is 4.5% less the ‘risk-free’ rate of 3%. The credit spread is therefore for 1.5%”
Swap will have 2 legs (Fixed vs floating) and floating can be linked to LIBOR.
A Swap is calculated based on LIBOR. A Swap spread is the difference between the Swap rate and the treasury yield of the same maturity. You do not use treasury rates to calculate swaps, you use LIBOR which is a bank-to-bank benchmark rate used to ‘justify’ lending rates.
Think of the swap spread as the difference between commercial and government rates.