A corporate bond has a yield to maturity of 5.80% and a nominal (G-) spread over the interpolated government benchmark of 150 bps. Its Z-spread, calculated using the full government spot rate curve, is 165 bps. Given an upward-sloping yield curve, this difference between the Z-spread and the nominal spread is best explained by:
- AThe nominal spread including a liquidity premium that the Z-spread excludes
- BThe Z-spread reflecting compensation for the bond's embedded call option
- CThe Z-spread capturing the effect of the curve's shape by discounting each cash flow at its own spot rate rather than a single point on the curve
- DA data error, since Z-spread and nominal spread should always be identical
Show answer & explanationAnswer & explanation
Correct answer: C. The Z-spread capturing the effect of the curve's shape by discounting each cash flow at its own spot rate rather than a single point on the curve
The Z-spread is the constant spread added to each point on the government spot rate curve needed to make the present value of the bond's cash flows equal its market price, so it fully reflects the curve's shape. The nominal (G-) spread simply compares the bond's YTM to a single interpolated point on the par curve, ignoring the shape of the term structure; on an upward-sloping curve, this typically causes the Z-spread to exceed the nominal spread.
Why the other options are wrong
- A. Reverses the concept; liquidity premiums are not distinguished by comparing Z-spread to nominal spread this way.
- B. The Z-spread does not isolate option value—that requires an option-adjusted spread (OAS).
- D. Incorrect; the two spreads are conceptually different and commonly diverge.
Z-Spread vs Nominal (G-) Spread
The Z-spread is the constant spread added to every point on the benchmark spot curve that equates the present value of a bond's cash flows to its price, while the nominal spread simply subtracts a single benchmark yield from the bond's YTM.
- Z-spread accounts for the full shape of the yield curve; nominal spread does not
- On an upward-sloping curve, Z-spread typically exceeds nominal spread
- Option-adjusted spread (OAS) = Z-spread minus the value of any embedded option
Memory trick: Z-spread zigzags along the whole curve; nominal spread just picks one point.