A z-spread, or zero-volatility spread, is the spread where the security’s discounted cash flows equal its present value on a spot yield curve. Its primary purpose for investors or traders is to measure the spread that can be captured over the yield curve if the security is held until maturity. It is a useful tool for analyzing a non-treasury security, as it measures its credit, liquidity and option risks. Z-spreads can also be used as an economic indicator, where a negative z-spread often indicates a recession is on its way. Calculating the z-spread requires trial and error to find the correct spread, using basis points so that the present value of cash flows and the bond’s price are the same.
Calculating the z-spread begins with adding basis points to each rate on the spot curve. For example, if the two-year rate on the spot curve is 4% with 50 basis points to be added, the rate would be 4.50%. An analyst can use this rate to calculate the present value of each cash flow and then add all of the cash flows together. The grand total of the cash flows should equal the security’s price. If these two numbers do not match, recalculations will need to be made using different spreads, or basis points, until the present value of the cash flows is the same as the bond’s price.
Advantages of a z-spread include its ability to be independent of other points on the yield curve. Unlike the nominal spread, the z-spread is not dependent on only one point of the yield curve, which allows it to be trusted by investors or traders. While z-spreads are most commonly used by investors and traders, it is sometimes used as an indicator of the health of the economy. For example, a negative z-spread can point to a looming recession.
Measuring the z-spread is not limited to any one spot rate curve, so calculations should clearly indicate which spot rate curve was used. For instance, a z-spread can use the security issuer’s benchmark spot rate curve to measure liquidity and option risk of this particular instrument. Short-term and high-rated debt will have little or no difference between the z-spread and its asset-swap spread. If there is a difference between these two spreads for this type of debt, then it can be safe to assume that the market has not priced this security accurately and adjustments will be seen shortly.