Spread risk – a ‘real-world’ lesson

In the Fall of 1998, fixed-income securities markets experienced unprecedented
volatility in response to the liquidity crisis (real or perceived) and ‘flight to quality’
that resulted from the turmoil in Russian and Brazilian debt markets and from
problems associated with the ‘meltdown’ of the Long Term Capital Management
hedge fund. As Treasury prices rallied, sending yields to historic lows, spreads on
corporate bonds, mortgage-backed securities and asset-backed securities all widened
in the course of a few days by more than the sum of spread changes that would
normally occur over a number of months or even years. Many ‘post-mortem’ analyses
described the magnitude of the change as a ‘5 standard deviation move’, and one
market participant noted that ‘spreads widened more than anyone’s risk models
predicted and meeting margin calls sucked up liquidity’ (Bond Week, 1998). Spreads
on commercial mortgage-backed securities widened to the point where liquidity
disappeared completely and no price quotes could be obtained. While there are
undoubtedly many lessons to be learned from this experience, certainly one is that
while a firm’s interest rate risk may be adequately hedged, spread risk can overwhelm
interest rate risk when markets are in turmoil.