Spread risk
The risk that a floating rate security loses value because its spread over the benchmark moves adversely, even though the benchmark yield itself has not changed.
In plain language
A floating rate security, or floater, does not pay a fixed coupon. Its coupon is the benchmark rate plus a spread. When the benchmark rises, the coupon rises with it, which is why floaters are sold as protection against rising interest rates.
But only the benchmark part floats. The spread is fixed when the security is issued.
Spread risk is what happens when the market's view of that spread changes. If investors now demand a bigger spread for this kind of paper, the floater's fixed spread looks too small. Its price falls, even though the benchmark has not moved at all.
The workbook's wording: "The yield of the underlying benchmark might not change, but the spread of the security over the underlying benchmark might increase leading to loss in value of the security."
So a floater protects you against benchmark moves. It does not protect you against spread moves.
How it works
How a floater is priced (Chapter 10). "Interest rates on floating rate securities (also called floaters) are specified as a 'Base + Spread'. For example, 5-year G-Sec + 2 percent", which means the coupon is 2 percentage points above the prevailing 5-year government security rate.
Why floaters usually hold value (Chapters 10 and 18). "In a floater, when yields in the market go up, the issuer pays higher interest; lower interest is paid, when yields in the market go down." Floating rate bonds have their coupon reset on each coupon payment date and "typically trade very close to their face value". Chapter 12 adds that floater funds' NAVs "tend to be steady".
Where that protection stops. The scheme risk factors in Chapter 10 list two risks specific to floating rate securities:
| Risk | What goes wrong |
|---|---|
| Spread risk | The coupon is a spread or mark-up over the benchmark; over the life of the security the spread "may move adversely leading to loss in value of the portfolio" |
| Basis risk | The benchmark may become less active or cease to exist, so it no longer captures interest rate movements |
A separate risk factor notes "very low liquidity in floating rate securities, resulting in lack of price discovery."
The link to credit spreads (Chapter 10). The returns of a debt portfolio are largely driven by interest rates and credit spreads. If an issuer's credit rating improves, "the market will now be prepared to accept a lower credit spread" and the security's value rises. Spread risk is the same mechanism in reverse: the required spread widens, and value falls. Rating migration risk (a one-notch downgrade from AAA to AA+ hurts price) is one way that can happen.
A worked example
Illustrative. The approximation ignores discounting and is only meant to show the direction and rough size of the effect.
A debt fund holds Rs 10 crore (face value) of a 3-year floating rate bond issued by a finance company at benchmark + 1.00%. The benchmark is 7.00%, so the coupon is 8.00%.
Six months later the benchmark is still 7.00%. But the market now demands benchmark + 1.50% from similar issuers.
Coupon the bond pays = 7.00 + 1.00 = 8.00%
Yield the market requires = 7.00 + 1.50 = 8.50%
Shortfall = 0.50% a year
The bond's spread is fixed at 1.00% until maturity, roughly 2.5 years away. A buyer will pay less to make up the shortfall:
Approximate shortfall per Rs 100 face = 0.50 × 2.5 = Rs 1.25
Approximate loss on Rs 10 crore = 10,00,00,000 × 1.25% = Rs 12,50,000
Compare the two shocks:
| Event | Coupon | Price effect |
|---|---|---|
| Benchmark rises 0.50%, spread unchanged | Resets to 8.50% at next reset | Price stays close to face value |
| Benchmark unchanged, required spread rises 0.50% | Stays 8.00% | Price falls (about Rs 12.5 lakh here) |
The floater protected the fund from the first shock and not the second, which is exactly the gap spread risk describes.
Why NISM asks about it
Chapter 10 (Risk, Return and Performance of Funds) sets out spread risk and basis risk under "Risk associated with floating rate securities", and explains floaters as "Base + Spread" and the role of credit spreads. Chapter 12 (Mutual Fund Scheme Selection) covers floater funds' steady NAVs, and Chapter 18 (Introduction to Interest Rate, Interest Rate Instruments and Fixed Income Markets) covers floating rate bonds and their coupon resets. Expect a question on which risk a floater still carries when the benchmark does not move (spread risk) and how it differs from basis risk.
Common exam traps
- Spread risk exists even when the benchmark yield does not change. That is the whole point of the definition.
- Floaters are protected from benchmark moves, not spread moves. "Floaters have no price risk" is wrong.
- Spread risk is not basis risk. Basis risk is the benchmark becoming less active or ceasing to exist.
- A widening spread hurts; a narrowing spread helps. An upgrade lets the market accept a lower spread and raises value.
- Spread risk is not default. The issuer can pay every coupon on time and the security can still lose value.
- The mark-up is part of the security's terms ("5-year G-Sec + 2 percent"); what moves is the spread the market demands over the benchmark.
Where this is taught
Free preparation for NISM Series V-DRelated terms
- Credit riskThe risk that a borrower fails to meet its obligations on a debt instrument — the risk credit rating agencies exist to grade, and the one that triggers a segregated portfolio in a mutual fund.
- Interest rate riskThe risk that an investor in a debt instrument loses return because rates rise — existing instruments carrying the old, lower coupon fall in value until their yield matches the new market rate.
- Modified DurationMacaulay's duration divided by (1 + yield) — the percentage by which a bond's price moves for a one percentage point change in interest rates, and so the standard measure of interest rate risk.
- Basis riskThe risk left over after hedging, because the exposure and the contract used to hedge it do not move identically — in size, in expiry date, or in what they are written on.
- Credit spreadThe extra yield a non-government borrower must pay over a government security of the same tenor — the market price of credit risk, quoted as an add-on over the risk-free rate.
- Floating rate bondA bond whose coupon is not fixed but reset at intervals against a benchmark rate plus a stated mark-up — so the interest paid moves with market rates over the life of the bond.
- Downgrade riskThe risk that a rating agency lowers an issuer's credit rating after an investor has bought its bonds, pushing the market price of those bonds down even if no payment is ever missed.