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The difference between the interest rate on three-month Treasury bills versus the three-month London Inter-Bank Offering Rate (LIBOR), is known as the TED spread.  The term “TED” arises from the 90 day T-bills and 90 Eurodollar (ED) certificates of deposit.  TED-based strategies can be viewed as credit spread trades, pitting highest quality government debt against slightly lower quality AA-rated inter-bank debt.

The TED spread is measured in basis points (bps) where 100 basis points = 1%.  For example, if LIBOR is 4.50% and 3-month T-Bills are trading at 4.10%, the TED spread would be 40 bp. The historic range of the spread has hovered between 10 and 50 bps, except during financial panics or downturns.

Recalling our discussion of the Capital Asset Pricing Model (CAPM), the risk-free rate is used as the basis for finding an asset’s or portfolio’s risk-premium. Well, that risk-free rate is none other than the 3-month T-bill rate – the “T” in TED.  LIBOR is by definition riskier, because it has more than zero risk that one of the counterparties to an inter-bank load will default.  Therefore, when the TED spread increases, investors are more concerned about counterparty risk, and thus demand a higher LIBOR (or equivalently, a lower price on Eurodollar securities) to induce them to assume the perceived extra risk.  Conversely, the TED spread decreases when credit conditions are considered benign.

TED is an inter-commodity spread - you can trade the TED spread by pairs-trading T-bills and Eurodollar CD’s, or more likely, the corresponding futures contracts.  If a hedge fund manager feels that credit conditions are going to worsen, he goes long the TED spread by shorting ED futures and buying T-Bills futures. The reverse trade, a short spread, favors the optimistic point of view regarding credit conditions, causing the spread to decrease.

You can also trade so-called term TED spreads, which use longer-maturity (i.e. 6 month, 9 month, etc) securities.

During the financial meltdown of 2008, the TED spread hit a record 465 bps, presaging the collapse of the interbank lending markets. Only massive injections of liquidity from central banks avoided a complete cratering of the financial system.  The tendency of such liquidity injections during times of financial crises tends to moderate the long-term volatility of the TED spread.

In our next blog, we’ll examine liquidity-based yield spreads.