hard · Debt Capital Markets pricing-yields-curve
A 7-year fixed-rate corporate bond trades at a Z-spread of 120 bp and an asset-swap (par-par) spread of 110 bp. The bond is priced at a premium (dollar price ~108). A trader claims the 10 bp gap proves the bond is 'cheap on an asset-swap basis relative to its Z-spread.'
What is the correct interpretation of the relationship between these two spreads here?
- The asset-swap spread is lower mainly because the par-par structure swaps the bond's above-par coupons against par notional, so the credit spread is earned on a larger swapped notional than the bond's market price, mechanically compressing it below the Z-spread for a premium bond.
- The 10 bp gap is pure arbitrage; an investor can buy the bond, pay fixed in the asset swap, and lock in 10 bp of risk-free spread to maturity regardless of the price.
- The Z-spread is overstated because it discounts cash flows on the swap curve while the asset-swap spread correctly uses the bond's own yield, so the true spread is 110 bp.
- The asset-swap spread is lower because it ignores the term structure of the curve, whereas the Z-spread reflects the steepness of forward rates, making 120 bp the richer measure of credit.
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