An alternative bond relative value measure: Determining a fair value of the swap spread using Libor and GC repo rates

During the 1990s, a reduced issuance in US Treasury, UK gilt and other sovereign bond markets resulted in the government bond yield curve being viewed as a potentially biased benchmark or indicator of fair value. This led to bond market investors starting to use the interest-rate swap curve as their main reference benchmark for valuation and analysis purposes. This reflected practitioners' views that continued exclusive reliance on government yields may lead to inaccurate analysis. The interest-rate swap curve is viewed as an acceptable alternative measurement benchmark. It is also used as a comparator instrument, against which the yields on government bonds can be measured. As the interest-rate swap market is considered to be sufficiently liquid and exposing users to inter-bank credit risk, considered a relatively low level of default risk, the swap curve can be viewed to be trading at a fair value to the theoretical zero-coupon yield curve. Such being the case, it is a key issue for investors to have comfort that the swap curve is fairly valued at all times. This enables them to use swap spreads over the government curve as a reasonable measure of the liquidity and fair value of government bonds. This paper provides an expression for the fair value for the swap spread, which is shown to be a function of the Libor rate and the general collateral repo rate. This spread can then be used as an alternative benchmark measure to assess relative value for all debt market instruments.