The I-spread is similar to the G-spread in that it uses an interpolated rate.
But instead of being based on government bond yields, it's based on interest rate swap rates.
Interest rate swaps are over the counter OTC instruments where broken or customer maturities off frequently traded, which means that reliable interpolation techniques have been developed and are widely used in the market For the I-Spread, we calculate the difference between the corporate bonds yield to maturity and the inter interpolated swap rate with a similar maturity.
Let's walk through an example.
We have a Deutsche Telecom bond with a maturity of January 17th, 2028, and a yield to maturity YTM of 2.432%.
To find the interpolated swap rate for a comparable maturity, we used two nearby swap rates.
In July, 2022, the applicable rates with a five year swap rate at 1.97% and the six year swap rate at 2.02%.
Since the exact maturity of the corporate bond does not match specific swap rate, we use an interpolation technique.
This technique involves estimating a rate between two known points, in this case between the five year and six year swap rates based on where the bonds maturity falls relative to these two points.
Conceptually, it's a way to calculate a blended rate that assumes a straight line relationship between the two swap points, giving us an estimate for the swap rate at our specific maturity.
After interpolation, we get an approximate swap rate of 1.989% for a maturity aligned with the corporate bond.
The eye spread is then calculated as the difference between the yield of the corporate bond and the interpolated swap rate.
In this case, that's 2.432% minus 1.989%, which equals 0.443%.
One advantage of the I-Spread is that it can be directly traded.
If an investor believes the I-Spread will decrease indicating a tightening of credit spreads, they could buy the corporate bond and enter into a swap with the same maturity as the bond where they pay the fixed rate.
This would create a position that benefits from a relative decline in the corporate bonds yield versus the swap rate.
And since interest rate swaps trade in the OTC market, the swaps terms can be negotiated to match the investors' needs.
Furthermore, in some markets, for example, in Europe, swaps may be a more suitable benchmark than government Bonds.
This is because there are multiple sovereign issuers with varying credit risks in the Eurozone leading to a fragmented government bond market.
In contrast, the swap market is unified and offers a consistent rate environment, making it an ideal reference for credit spreads.
However, one caveat of the I spread is that swap rates, particularly those against eyeball benchmarks, are not purely credit risk free swap rates are effectively the time weighted average of anticipated reference rates over the lifetime of the swap.
As IBOR rates can be influenced by perceptions of counterparty risk in the banking system.
Swap rates might increase relative to, for example, government bond yields.
If they were concerns about counterparty risk in IBOR.
This means that in times of banking sector stress, the eye spread might widen or narrow for reasons unrelated to the corporate bond issuers credit risk, potentially incorporating shifts in the broader financial sector's risk perception.
