Floating–Fixed Credit Spreads

We examine the term structure of yield spreads between floating-rate and fixed-rate notes of the same credit quality and maturity. Floating–fixed spreads are theoretically characterized in some practical cases and quantified in a simple model in terms of maturity, credit quality, yield volatility, yield-spread volatility, correlation between changes in yield spreads and default-free yields, and other determining variables. We show that if the issuer's default risk is risk-neutrally independent of interest rates, the sign of floating–fixed spreads is determined by the term structure of the risk-free forward rate. We discuss the term structure of yield spreads between floating-rate and fixed-rate notes of the same credit quality and maturity. Floating–fixed spreads are theoretically characterized in some practical cases and quantified in a simple model in terms of maturity, credit quality, yield volatility, correlation between changes in yield spreads and default-free yields, and other determining variables. We show that if the issuer's default risk is risk-neutrally independent of interest rates, the sign of the floating–fixed spread is determined by the term structure of the risk-free forward rate. For example, if the term structure of default-free rates is increasing up to some maturity, then spreads on floating-rate debt are larger than spreads on fixed-rate debt. Conversely, under the same independence assumption, if the default-free term structure is inverted, floating-rate spreads are smaller than fixed-rate spreads. Intuitively, if the term structure is upward sloping, investors anticipate that floating-rate coupons are likely to increase with time. Default risk for a given issuer increases with time because the issuer cannot survive to a particular time unless it also survives to each time before that date. Because the higher anticipated coupon payments of later dates are also the more likely to be lost to default, investors must be compensated by a floating-rate spread that is slightly larger than the fixed-rate spread. In terms of magnitude, however, in most practical cases, floating–fixed spreads are small, typically (as is shown by example) a few basis points at most. Our persistent queries to market practitioners have generated no examples in which market participants make a distinction between par floating-rate spreads and par fixed-rate spreads except for certain cases in which one of these forms of debt is viewed as “more liquid” than another, an issue that we do not pursue. For example, consider an issuer whose credit quality implies a fixed-rate spread on five-year par-coupon debt of 100 basis points (bps) over the rate on default-free five-year par-coupon fixed-rate debt. Suppose changes in credit quality are not correlated with state prices (in a sense that is made precise). In a typical upward-sloping term-structure environment, based on the steady-state behavior of a two-factor Cox–Ingersoll–Ross model fitted to LIBOR swap rates recorded during the 1990s, floating-rate debt of the same credit quality and maturity would be issued at a spread of roughly 101 bps. This is, of course, not to say that the issuer should prefer to issue fixed-rate rather than floating-rate debt but, rather, that a slightly higher credit spread is required to compensate investors paying par for floating-rate debt. As suggested by this example, the magnitude of the floating–fixed spread associated with default risk is sufficiently small that one could safely attribute any nontrivial differences that may exist in actual fixed and floating rates of the same credit quality to institutional differences between the fixed- and floating-rate note markets. For our model, the floating–fixed spread is roughly linear in the issuer's fixed-rate credit spread, roughly linear in the slope of the yield curve, roughly linear in the level of the yield curve, and roughly linear in the correlation between changes in default-free yields and fixed-rate yield spreads. The floating–fixed spread is nonlinear in maturity. When the slope is held constant, there is essentially no dependence in the level of the yield curve. The floating–fixed spread is greatest at high-yield-spread volatility and at high correlation between yield spread and default-free yields.