Drivers of Inflation-Linked Corporate Bond Spreads and the Inflation Swap/Bond Breakeven Difference

Abstract

Spreads of inflation-linked corporate bonds over TIPS are considerably tighter than spreads of corporate bonds over nominal Treasuries. A related phenomenon is that inflation swaps rates are higher than bond “breakeven” inflation rates for the same maturities. The typical explanation for this phenomenon is that imbalances of inflation receivers over inflation payers in the CPI swaps market causes implied inflation to be mispriced in inflation swaps. Since all corporate linker issues to date have been swapped, this results in abnormally tight spreads in the corporate market. I demonstrate that the difference in spreads can be attributed to the Treasury curve, which trades richer than it should by an amount reflecting the value of the stream of special financing that redounds to the benefit of the Treasury buyer. TIPS, contrariwise, rarely trade special; therefore, the abnormally tight spreads in the corporate linker market and the difference between the bond and swap curves result from the fact that these spreads are measured against a cheaper sovereign curve.