SWAP SPREADS MIRED IN NEGATIVE TERRITORY
By Rom Badilla, CFA – BondSquawk:
Many people including mainstream media are scratching their heads on today’s action as the yield on 10-year interest rate swaps traded well below the yield on 10-year U.S. Treasuries.
Theoretically, such a dynamic should not happen since Treasuries are backed by the safest creditor in the world while entering into an interest rate swap agreement subjects an investor to credit risk stemming from the counterparty, such as a bank or financial entity. Such risk should command incremental return to the investor in the form of higher yield and thus a positive spread between the riskier swap and the risk free Treasury. This was not the case as the spread entered into negative territory for the first time in recent history.
There are three catalysts that point to this event with the first being the Federal Reserve’s latest policy statement suggesting that short term interest rates will remain low and accommodative for the foreseeable future. Essentially, the Fed will keep the Fed Funds rate at current levels until improvement in the country’s unemployment rate and as long as inflation remains subdued. The second is the waning demand for U.S. Treasuries as evident by today’s auction and increasing risk for sovereign debt such as Greece and Portugal, which was downgraded by Moody’s today to AA-. Each fact points to higher yields. The third catalyst is the impending amount of corporate debt issuance.
The best way to illustrate this is to analyze it is from the perspective of a corporation that is looking to issue debt and minimize the subsequent interest expense. This can be done particularly in this rate environment by issuing out floating rate debt, which closely tracks short-term rates like the Fed Funds rate. Since the Fed Funds rate should remain low and anchored due to the aforementioned reasons, this is ideal for a corporation. However, investors who are trying to maximize returns prefer to receive a higher set or fixed coupon that will closely resemble the 10-year note (plus credit spread commensurate with the corporation).
In order to bridge this gap of needs, a corporation will cater to investors by issuing debt with a higher fixed coupon. Unfortunately, with longer maturity yields tracking higher due to the aforementioned reasons of the weak Treasury auction and the increasing sovereign risk, this is far from ideal for the corporation. This can be circumvented by entering into an interest rate swap agreement with a counterparty, such as a bank.
The swap agreement will allow the corporation to receive a fixed rate from the bank, which will offset the fixed rate amount paid to investors on the debt, in exchange for paying a floating rate to the bank. In essence, by entering into a swap agreement, a corporation is able to reach its goal of issuing debt and minimizing interest expense.
So going back to today’s environment where on the horizon, large amounts of corporate debt issuance is hitting the market with not enough counterparties to offer swap agreements, the price increases (in the form of declining yield on the interest rate swap) due to higher demand and insufficient supply. This market imbalance is the reason why swap spreads on the longer end of the curve turned negative and counter to market theory.
While it is difficult to gauge how long this imbalance will persist, I do think that 10-year swap spreads will revert to its proper relationship. I think that if the corporate calendar finds a respite and if market volatility spikes (VIX jumped 7.3 percent today) due increasing sovereign risk, equity weakness, mounting Treasury supply, or some combination, swap spreads could widen back into positive territory where it belongs.
When the 30 year swap spread went negative I remember people saying it would never last…Yet here we are 18 months later and its still negative (-27bps)
The problem here is that the market suddenely realised, post-Lehman, that LIBOR is “just a number” written up on a chalkboard every day by a few large banks. It is easily manipulated…several stories in the post-Lehman days of banks low-balling the number to avoid looking as if they were having trouble financing.
So at the end of the day, why would anyone hold a 30-year derivative where the cashflows are based off a number, where in times of stress banks may try game the system?
Same goes for a 10 year swap now. You need to hang on for 10 years to “arbitrage” the contract. Yet in the meantime you expose yourself to all the risks above
So what if 10 year treasurys yield 3.8%…If banks say they borrow below that on average over the next 10 years…You just have to take their word for it!!
LIBOR is just a number. Treasury’s have real cashflows which you cannot dispute
I can see why some large hedge funds refuse to have any OTC derivative exposure longer than 18 months now!
you seem to be a bit mixed up there mikie. if no one wanted to own a 30 year derivative with cash flows based on a number then the rates for the 30yr swap would be higher. in reality, people would rather hold a 30 year derivative than a 30 year treasury. the biggest reason, IMO, is that you gain the duration exposure without taking a hit to your balance sheet. if you want to get long 30 year paper, you can do it with a swap or by purchasing a treasury. when you enter a swap, no money is exchanged at the point of sale. when you purchase a treasury, you have to put up the money (or borrow it).
david goldman had a great piece on why 10y swap spreads have contracted so much. it used to be that the biggest payer on 5 and 10y swaps were mortgage accounts hedging their duration. now that the fed owns almost all the outstanding mortgages, there is no one left to pay on swaps. this has created a supply/demand imbalance.
Hi Vol Trader,
on your point regarding balance sheet…it is true one would have to put up some capital to own treasuries. However, as a risk free asset (in theory) the amount of capital that needs to be put up is amongst some of the lowest in any asset class.
Even though swaps have off balance sheet treatment, doesn’t it still require some form of collateral or capital charge to the swap holder? And if so is that number usually less than holding a similar maturity Treasury?