Fixed Income
Understanding I-Spread
When bonds are compared to a benchmark, the choice of benchmark matters. Government bond yields are often used, but they are not always the best reference, especially when the government curve itself is distorted by policy or supply factors. This is where the I-spread becomes useful.
I-spread measures the yield difference between a bond and the swap rate of the same maturity. Because swap rates reflect interbank funding conditions, I-spread is often considered a cleaner measure of credit risk.
What I-Spread Really Measures
The I-spread is the difference between a bond’s yield to maturity and the fixed rate on an interest rate swap with the same maturity.
In simple terms, it shows how much extra yield a bond offers over the swap curve rather than over a government bond.
I-spread is commonly used in markets where swap curves are viewed as a better representation of risk-free or near risk-free rates.
How I-Spread Is Calculated
The calculation is straightforward.
Take the yield to maturity of the bond.
Subtract the swap rate of the same maturity.
I-Spread = Bond yield − Swap rate
Exams usually focus on interpretation and benchmark choice rather than numerical difficulty.
Why Swap Rates Are Used as the Benchmark
Swap rates reflect the borrowing cost between banks and are closely linked to money market conditions. Unlike government bonds, swap rates are less affected by issuance patterns or central bank buying.
Because of this, the swap curve is often smoother and more consistent across maturities.
I-spread therefore isolates credit risk relative to interbank funding risk rather than sovereign risk.
Interpretation of I-Spread
A higher I-spread indicates that the bond offers more compensation relative to the swap benchmark. This usually reflects higher credit risk or lower liquidity.
A lower I-spread suggests the bond is closer in risk profile to high-quality issuers.
I-spread is best used for comparing bonds with similar structures and maturities.
I-Spread Versus G-Spread
This comparison appears frequently in exams.
G-spread uses a government bond yield as the benchmark.
I-spread uses a swap rate as the benchmark.
When government yields are distorted, I-spread often provides a more stable comparison. Understanding why the benchmark differs is more important than memorising formulas.
I-Spread Versus Z-Spread
I-spread compares yields at a single maturity point.
Z-spread adjusts the entire yield curve by a constant spread.
Z-spread is more precise for bonds with fixed cash flows, while I-spread is simpler and faster to compute.
Exams may test which spread is more appropriate in different situations.
When I-Spread Works Best
I-spread is most useful when:
- Bonds have fixed cash flows
- No embedded options are present
- The swap curve is considered a reliable benchmark
It is commonly used in corporate bond analysis and international fixed-income markets.
Limitations of I-Spread
One limitation is that swap rates themselves include some level of credit risk. They are not truly risk-free.
Another issue is that I-spread relies on a single maturity point and does not account for yield curve shape.
These limitations are often tested conceptually rather than numerically.
Common Exam Confusions
Students sometimes assume I-spread measures only credit risk. Like other spreads, it also captures liquidity risk.
Another common mistake is applying I-spread to bonds with embedded options without adjusting for option effects.
Exams may also test whether candidates understand that I-spread depends on swap market conditions.
Final Thought
I-spread provides a useful alternative to government-based spread measures by using the swap curve as a benchmark. It offers a clearer view of credit risk when government yields are distorted or unreliable. For exam preparation, focus on why swap rates are used, how I-spread differs from G-spread and Z-spread, and when it is most appropriate. Once this intuition is clear, I-spread questions become much easier to handle.
