Barbican Consulting Limited
Swap Spreads
What is the swap spread?
The swap spread is the difference in yield between the interest rate swap (IRS) market and the government bond market. Normally you would expect the swap rate to be higher than the yield on similarly dated government bonds but this relationship can and does change. When it does it not only affects dealers who speculate but it can affect those intending to hedge, so it may affect you. Let's see how.
Why the swap spread is important
Swap traders hedging with government bonds are directly exposed to swap spread risk. This may arise in the normal course of business or it may be the result of a specific “bet” on the spread. You could be forgiven for thinking that it’s only these dealers that are affected. That simply isn’t true. Investors managing assets, treasurers managing liquidity and companies arranging long term finance are all affected by swap spreads.
Furthermore with the rigorous application of mark-to-market and IAS 39 any change in the swap spread could lead to changes in your reported profit and loss. These are changes that you may not have anticipated. When you read the following think about where you could be exposed in your business. It may not be immediately obvious but if you do any of the following you could be affected:
Investing in government debt (Gilts) for liquidity and hedging your interest rate risk with swaps;
Investing your reserves in government debt and hedging with swaps;
Issuing a fixed rate bond and swapping back to floating rate;
Asset swapping higher yielding bonds to increase your investment return.
Risk quantification
Normally the change in swap spreads is slow but over a period of time the cumulative change can be great. If you get on the wrong side of this it’s Chinese torture - death by a thousand cuts! To put things in perspective let’s look at a few numbers.
Suppose you buy £10m of 20 year government bond (it could be a Gilt) for liquidity or investment purposes. Then you swap this to a variable rate. Your interest rate is hedged but what about your swap spread risk?
For each basis point the swap spread narrows you will lose approximately £12,500. Not much. But if the spread widens by 50 basis points that becomes £625,000 and by many standards that’s not a big position. Could it happen? What do you think? I’m sure you could come up with some scenarios where it could.
So if you do buy Gilts (or any other government bond) and hedge with swaps you are entering what dealers call a “spread trade”. Should you do it? That’s your call. So what could influence whether you gain or lose? Any of the following.
1. Quantitative easing and the exit strategy
Quantitative Easing (QE) has been adopted by central banks in order reduce the threat of deflation. It involves the purchase of bonds in order to increase cash balances. What effect does this have on the government bond market? It depends on the size of the programme and what bonds are purchased. Where the main recipient of QE is the government bond market government yields fall.
As government bonds become relatively expensive the swap spread can widen. Good news if you hold bonds hedged with swaps. In such a scenario you would gain. But what happens when QE is reversed?
That’s not certain because it’s not clear when and how the reversal will take place. But if it means a reduction in bond purchase and then the sale of bonds by the authorities you would anticipate bond yields to rise. In this scenario the swap spread could widen and your earlier profit would evaporate.
2. Fiscal needs
Increased bond issuance by the government as a result of funding requirements tends to increase longer term interest rates. This can cheapen the government bond market relative to the swap market leading to a narrowing of swap spreads. Although higher interest rates are historically associated with wider swap spreads.
Unexpected alterations in the funding or issuance profile by the government may also affect spreads. For example if the government announced that it was not going to issue five year bonds liquidity would decline, yields would rise and the swap spread would narrow at this point in the curve.
Altering the maturity of the government funding profile can have a similar affect. More short term debt and less long term paper would tend to widen the spread at the longer end of the yield curve and narrow it at the shorter end.
3. Credit spreads
The swap spread has traditionally been considered a “quality spread” representing the credit differential between the banking system and government bonds. In times of stress in the banking system there is a flight to quality and the swap spread widens. Shorter maturities are often more affected.
Corporate credit spreads also have an affect on swap spreads. If there is a search for cheaper higher yielding bonds and a willingness to invest in more risky assets credit spreads narrow and outperform. As credit spreads contract there will be pressure on swap rates to maintain their relative differential and swap rates too will tend to decline narrowing the swap spread.
4. Corporate hedging strategies
Large bank and corporate treasuries can and do trade on their expectations about interest rates. If rates are anticipated to rise they may decide to pay fixed interest in the swap market therefore gaining from their rate expectation. A large number of fixed rate payers tends to increase swap rates and widen the swap spread.
5. Weak stock markets & pension liabilities
Weak stock markets have forced companies to reconsider how they hedge and manage long term pension liabilities. A switch out of equities into fixed income increases demand for fixed income securities. An alternative trade for some portfolio managers is to receive fixed in the swap market. (This synthetically creates a bond position). This action increases the number of fixed rate receivers in the swap market narrowing the swap spread.
6. New issues
New issues are both influenced by and have influence on the swap spread. A fixed rate bond issuer may wish to swap to a floating rate. The issuer will receive fixed interest in the swap market for a maturity matching that of the bond. The resultant floating rate cost will depend on:
The issuer’s fixed rate cost of funds
The swap rate
The higher the issuer’s funding cost relative to the swap rate, the higher will be the swapped cost of borrowing.
If the swap spread widens (and all other factors remain constant) the issuer’s floating rate funding cost will decline. This can trigger the issue.
Fixed-rate bond issuance can also feedback to the swap spread. If the amount of issuance is large enough or concentrated it can narrow the swap spread.
7. Asset Swaps
The asset swapper is paying fixed interest to the swap market and receives a floating rate in return. The floating rate normally has a margin that is dependent on the credit standing and liquidity of the underlying asset being swapped.
Increased asset swap activity can lead to an increase in the swap rate and a widening in the swap spread.
8. Repo trades and swap spreads
A trader paying fixed rate can buy a similar maturity government bond in order hedge the interest rate risk. To fund the bond purchase, the trader may use the repo market.
This trade will benefit if swap spreads widen, (government bonds become more expensive relative to swaps). Conversely the trader will lose if spreads narrow.
Because the repo rate is the effective short term interest rate used to finance the bond it can affect the swap spread.
Repo rates for “on-the-run” issues can be low or “special”, this allows the trader to fund the bond cheaply. The trader benefits from positive carry.
This encourages the trade increasing demand to buy the bond and pay fixed interest in the swap market thus widening the swap spread.
9. Structured products
Some structured products are hedged using swaps. Here is a classic example. Reverse floating rate notes pay investors a fixed interest rate minus Libor. So when interest rates fall the return increases, hence the name, reverse FRN.
An issuer of a reverse FRN can and does swap the note coupon back to a normal Libor linked cost of funds. To do this the issuer is a fixed rate receiver in the swap market, (often for an amount that is a multiple of the FRN issuance). The result is to compress swap spreads around the maturity of the FRN.
Mind how you go!
Swaps are regularly used by many firms in the normal course of business to manage interest rate risk. There is nothing wrong with this. However if you hedge using swaps you may be subject to swap spread risk. Being aware of the consequences in a mark-to-market environment is important. Events beyond your control can adversely affect your position.
First Published by Barbican Consulting Limited 2009