May 24, 2012

Faculty of Business Administration and Economics

Yield Spreads, Value of Bonds, and Implications for Liquidity

ManagementProf. Dr. Mario Strassberger

Finance and Financial Services

Slide 1

Conference “International Competition in Banking: Theory and Practice”

May 24-25, 2012, Ukrainian Academy of Banking, Sumy

May 24, 2012 Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications

Structure of the Talk

1 Introduction2 Design and Data3 Results4 Conclusion

Slide 2

May 24, 2012

1 Introduction

Bond portfolios in financial institutes- Means of liquidity reserve- Assuring refinancing with the Central Bank, i.e. ECB

Considerable losses to the value of bond portfolios during the crisis

Requirements and recommendations for liquidity risk of the banking supervision (Basel Committee 2008, 2009; CEBS 2008)

One of the key demands: Maintenance of an adequate level of liquidity

What dos “adequate” mean? Reliable estimation of haircuts on bond values

Slide 3Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications

May 24, 2012

2 Design and Data (1)

Bloomberg Fair Market Curves™- Sector: EUR Composite- Credit qualities: AAA, AA, A and BBB- Maturities: 1Y, 3Y, 5Y, 7Y, 10Y, 15Y and 20Y- Benchmark: Government Curve

Two data sets- Jan 04 – Jul 07 (Set 1, 1,308 observations)- Aug 07 – Dec 10 (Set 2, 1,249 observations)

Yield spread at time

Slide 4

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Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications

May 24, 2012

2 Design and Data (2)

Example of time series

Slide 5

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Yields at maturity 1Y

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Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications

May 24, 2012

2 Design and Data (3)

Example of time series

Slide 6

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Yield spreads at maturity 1Y

AAA AA A BBB

Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications

May 24, 2012

2 Design and Data (4)

1) Estimating exp. spreads and p-quantiles of the spread distr. (Set 1) Identifying max. observed spreads (Set 2)

2) Calculating relative changes in Present Value of zero bonds caused by spread expansions

and interpreting as haircut

Slide 7

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Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications

May 24, 2012

3 Results (1)

Slide 8Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications

1Y 3Y 5Y 7Y 10Y 15Y 20Y

AAA 12.14 16.81 18.94 18.59 21.36 20.10 31.36

AA 17.08 24.03 25.38 25.28 29.85 35.61 42.32

A 23.72 34.41 39.00 40.72 48.86 59.77 67.92

BBB 38.25 57.39 70.93 78.87 94.61 110.20 132.63

Table 1 Expected yield spreads in basis points

1Y 3Y 5Y 7Y 10Y 15Y 20Y

AAA 26.86 23.41 32.46 30.13 40.19 36.92 49.96

AA 32.10 38.60 45.56 43.01 52.72 52.11 79.65

A 43.73 52.44 62.05 60.61 77.52 99.78 105.08

BBB 81.49 105.69 116.76 111.51 129.35 170.48 260.66

Table 2 99.99%-quantile of the yield spread distributions in basis points

Considering Set 1

May 24, 2012

3 Results (2)

Spreads up to 13 times higher than expected (regular market cond.)

Increase in spreads mainly driven by liquidity premiums

Slide 9Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications

Considering Set 2

1Y 3Y 5Y 7Y 10Y 15Y 20Y

AAA 200.60 156.50 299.40 144.10 142.90 121.90 75.20

AA 215.60 174.80 320.90 183.70 195.00 144.65 137.98

A 285.00 267.80 335.20 265.00 272.00 266.40 214.90

BBB 391.08 398.50 412.60 432.20 461.20 403.30 444.40

Table 3 Maximum observed yield spreads in basis points

May 24, 2012

3 Results (3)

Slide 10

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Empirical frequency of yield spreads (AAA, 1Y)

Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications

May 24, 2012

3 Results (4)

Haircuts of up to 25% for investment grade bonds

Ex ante underestimation of spreads and haircuts (regular market cond.)

Slide 11Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications

Calculated haircuts

1Y 3Y 5Y 7Y 10Y 15Y 20Y

AAA -1.04 -2.55 -8.91 -5.96 -8.40 -10.37 -6.01

AA -1.09 -2.75 -9.36 -7.45 -11.22 -11.05 -12.62

A -1.43 -4.21 -9.37 -10.35 -14.81 -19.80 -18.65

BBB -1.92 -6.07 -10.69 -15.72 -22.98 -26.73 -35.17

Table 4 Haircuts on zero bonds in %

May 24, 2012

4 Conclusion

Maintaining an adequate level if liquidityholding portfolios of liquid securities+ individual additional charge on liquidity reserve (up to 1/3 more in present value than needed to

assure liquidity)

Increasing importance to minimise estimation errors of bond haircuts

Liquidity shock could persist for several months

Additional discount on actual market value to ex ante account for a crisis

Slide 12Prof. Dr. Mario Straßberger, Yield Spreads, Bond Values, and Implications