Static Spread

What is Static Spread?

Static spread, otherwise called zero-volatility spread or Z-spread, is the constant yield spread added to all spot rates on the Treasury curve to adjust the present value (PV) of a bond's cash flows to it's current price.

Understanding Static Spread

The yield spread is the difference in yields between two yield curves. The yields on a yield curve which incorporates T-bills, T-notes, and T-bonds, are called the Treasury spot rates. The spread is the amount of yield that will be received from a non-Treasury bond over the yield for the equivalent maturity Treasury bond. Take the case of an investor contrasting the Treasury yield curve with a corporation's yield curve. The interest rate on 2-year T-notes is 2.49% and the yield on the comparable 2-year corporate bond is 3.49%. The yield spread is the difference between both rates, which is, 1% or 100 basis points.

A static, or constant, spread of 100 basis points means that adding 100 basis points to the Treasury spot rate that applies to the bond's cash flow (interest payments and principal repayment) will make the price of the bond equivalent the present value of its cash flows. In other words, each bond cash flow received is discounted at the appropriate Treasury spot rate plus the static spread.

Static spread is calculated by trial-and-mistake. An analyst or investor would need to try different numbers to figure out which number when added to the present value of the non-Treasury security's cash flows, discounted at the Treasury spot rate, will rise to the price of the security in question.

For instance, take the spot curve and add 50 basis points to each rate on the curve. Assuming the two-year spot rate is 2.49%, the discount rate you would use to find the present value of that cash flow would be 2.99% (calculated as 2.49% + 0.5%). After you have calculated every one of the present values for the cash flows, add them up and see whether they equivalent the bond's price. On the off chance that they do, you have found the static spread; if not, you need to return to the drawing board and utilize another spread until the present value of those cash flows equals the bonds price.

The static spread varies from the nominal spread in that the latter is calculated on one point on the Treasury yield curve, while the former is calculated utilizing a number of spot rates on the curve. This translates to discounting each cash flow utilizing its period to maturity and a spot rate for that maturity. Accordingly, static spread is more accurate than nominal spread. The main time where the static spread and the nominal spread would be equivalent is assuming the yield curve was perfectly flat.

Static or Z-spread calculations are frequently utilized in mortgage-backed securities (MBS) and other bonds with embedded options. A option adjusted spread (OAS) calculation, which is frequently used to value bonds with embedded options, is essentially a static spread calculation in view of multiple interest rate paths and the prepayment rates associated with each interest rate path. The static spread is likewise widely utilized in the credit default swap (CDS) market as a measure of credit spread that is relatively insensitive to the particulars of specific corporate or government bonds.

Highlights

• Static spread is calculated by trial-and-mistake.
• Static spread is more accurate than the nominal spread given that the latter is calculated on one point on the Treasury yield curve, while the former is calculated utilizing a number of spot rates on the curve.
• Static spread, otherwise called zero-volatility spread or Z-spread, is the constant yield spread added to all spot rates on the Treasury curve to adjust the present value (PV) of a bond's cash flows to it's current price.