Government securities have traditionally been used as benchmarks for long-term interest rates. Today the market for interest rate swaps is also used. The difference between yields on government bonds and swap market rates--the swap spread--can provide information about the properties of these markets as reference markets. This article considers factors that may influence variations in the swap spread in Norway. An econometric analysis shows that in the period 1997-2003, the swap spread varied with developments in the spread between short-term money market rates and government bond yields, price developments in equity markets and the issuance of Eurobonds denominated in NOK. The results provide support for the use of the swap market as a benchmark market when pricing corporate bonds.
In financial markets it is usual to price financial instruments relative to comparable investment alternatives (relative pricing). When pricing a bond, one can use the market rate of comparable bonds as the basis, and price components that are specific to the individual bond. For example, the yield on a corporate bond could be priced as the yield on a government bond of the same duration (1) with a premium corresponding to the credit and liquidity risk associated with the corporate bond. The yield on the government bond can then be regarded as the benchmark for the corporate bond.
Pricing relative to a benchmark contributes to consistent pricing of underlying factors that are common to different bonds, and at the same time simplifies pricing. Relative pricing also makes it easier to compare prices for different bonds. However, smoothly functioning and effective pricing is contingent on the existence of suitable benchmarks. In Norway, the government bond market and interest rate swap market are the most relevant reference markets for long-term rates and hence for the pricing of corporate bonds. (2) In the article we consider various factors that influence the choice of whether to use government bond yields or swap rates as long-term benchmark rates in Norway. The assessment is based partly on a theoretical discussion, and partly on an econometric model of developments in the spread between the rates in the two markets--the swap spread.
The role of a benchmark instrument
The basic premise for the choice of a benchmark instrument is that the value of the instrument is fundamentally similar to that of the instrument that is to be priced. The reference instrument should contain few value components that are specific to the instrument. In other words, an appropriate benchmark instrument should reflect as "purely" as possible components that are relevant to the value of the instrument that is to be priced. If we assume that the yield on a corporate bond consists of a required risk-free real rate of return, inflation expectations and compensation for credit risk (3), the requirement for an appropriate benchmark rate for the bond will be that it covaries as closely as possible with these components. The yield on the corporate bond must be adjusted for factors that are specific to the corporate bond and any components of the benchmark rate that are not relevant to the corporate bond.
Government bonds as benchmarks
Government bond yields have traditionally been used, both internationally and in Norway, as fundamental benchmarks for the pricing of corporate bonds. A large outstanding volume, long and spread maturity profile and the absence of credit risk have made government bonds appropriate for reflecting the market's required real rate of return and inflation expectations. (4) Moreover, government bonds are homogeneous instruments that are available to all investor groups, and they are sold in transparent markets. When government bond yields are used as benchmarks for pricing corporate bonds, a premium must be estimated for the credit risk associated with the corporate bond, since there is no credit risk associated with the yield on government bonds. (5)
The Norwegian government bond market is small by international standards. It is also small relative to macroeconomic aggregates for Norway such as GDP. (6) This is because the public sector borrowing requirement is limited. For the same reason, the Norwegian government bond market is less liquid (7) than most other bond markets. Because of the poor liquidity and low outstanding volume, Norwegian government bond yields may be considerably influenced by variations in supply and demand that do not reflect changes in the required real rate of return or inflation expectations. This reduces the suitability of Norwegian government bonds as benchmarks for long-term rates and corporate bonds.
Swap rates as an alternative to government bond yields
In the late 1990s, government borrowing in many countries was reduced because of government budget surpluses. (8) The result was reduced liquidity in the countries' government bond markets and market participants looked around for alternative benchmark instruments. Among the alternatives to government bonds are semi-government bonds and government-guaranteed bonds, interest rate swaps, investment grade corporate bonds and bonds issued by supranational organisations. (9) In most countries, interest rate swaps have emerged as the most appropriate alternative.
Information from market participants indicates that interest rate swaps are used extensively as a reference for long-term rates and pricing of corporate bonds. This applies both internationally and in Norway. Interest rate swap markets have grown strongly in recent years, and in a number of countries the liquidity of these markets is greater than that of government bond markets.
Pricing of corporate bonds
The Norwegian market for corporate bonds is small. Few companies issue bonds compared with other countries, and the amount outstanding is usually relatively low. Moreover, turnover of most bonds is very low. Thus, few indices for corporate bonds can provide a continuous and satisfactory picture of developments in the corporate segment of the Norwegian bond market. This makes it difficult to determine which references are used in the corporate bond market.
Banks are the largest borrowers in the corporate bond market. Since banks are also the largest participants in the swap market, the credit risk component of the yield on bonds issued by banks is closely linked to the credit risk component of swap rates. Covariation between swap rates and yields on corporate bonds can therefore be explained in terms of both variations in the required real rate of return and inflation expectations and variation in the credit risk associated with market participants' risk profile.
Chart 2 shows developments in spreads for swaps with maturities of 5 and 10 years and the spread between the yield on bonds in the BRIX index and in the ST4X (10) government bond index on the Oslo Stock Exchange (the BRIX spread) in the period 1997 to end-2003.
The chart indicates a high degree of covariation between these spreads through the period. The BRIX index is based on a selection of listed bank, insurance, mortgage company and industrial bonds, and has a duration of 3 years. Since 2002, the index has contained almost exclusively bank bonds. All else being equal, one would expect the BRIX spread to be wider than the swap spread, because credit risk components are larger in the bond market, where also the principal is exchanged between seller and buyer.
Chart 3 presents an example of how the yield on a corporate bond (NOKR98) develops relative to government bond NST 465 (11) and the swap rate with the same maturity as NST 465. (12) The chart also shows the swap spread with the same maturity in the same period. We see that NOKR98 (13) follows the swap rate more closely than the government bond yield for most of the period. This is reflected by the fact that that the spread between NOKR98 and the swap rate changes relatively little through the period, and similarly that the spreads between government bond yield and NOKR98 and the swap rate, respectively, are very largely parallel. This was also the case in the period in autumn 2002 when the swap spread widened appreciably, partly due to extensive demand...