The Relationship Between Issuance Spreads and Credit Performance of Structured Finance Securities

Abstract

This Special Comment analyzes the relationship between structured finance par coupon spreads at issuance and the securities' credit ratings. Our data sample covers a seven-year period from 1998 to 2004, and includes floating and fixed rate securities that were rated investment grade (Baa3 or above) at origination.

The major findings are:

• Spreads vary as expected across rating categories, with spreads on lower rated securities considerably higher than spreads on higher rated securities. • Spreads vary substantially over time and across asset classes; the spreads on structured finance securities are generally wider than those on similarly rated corporate securities. • Spreads in structured finance are generally positively correlated with those in corporate finance. The correlations appear to vary by rating category and asset class. • Spreads typically widen when the structured finance one-year speculative-grade impairment rate or corporate one-year speculative-grade default rate rises. Spreads also vary with the three-month LIBOR rate and the slope of the swap rate curve. • Spreads are backward looking in the sense that new issue spreads widen after downgrade rates rise on outstanding securities within the same asset class. • Spreads also anticipate future credit performance in the sense that securities with wider spreads at issuance (conditional on sector, rating, and general market conditions) are more likely to experience subsequent rating downgrades than other securities. • A number of important simplifying assumptions are used to facilitate the analysis. In particular, all fixed rate spreads are measured by comparing each tranche's par coupon rate to the five-year swap rate, regardless of the security's expected average life. Moreover, all floating rate spreads are expressed as spreads over three-month LIBOR rates, by adjusting for the prevailing difference between the security's benchmark interest rate and the three-month rate. We believe that a relaxation of these assumptions would not change any of the conclusions stated above. In future studies, however, we hope to use better spread measures and carefully account for differences in average lives and differences in benchmark interest rates across securities.

Keywords: credit spreads, credit ratings, structured finance