There has been some excitement lately about the fact that 10-year swap spreads in the U.S. have turned negative. For those in Canada with some knowledge of interest rate swaps, it is important to understand the primary drivers of swap spreads, what has happened to swap spreads in Canada as the financial crisis evolved and why negative spreads have garnered so much attention.
An interest rate swap is an agreement to exchange fixed cash flows for floating cash flows, which are determined by an index such as LIBOR or CDOR. The fixed cash flows can be viewed as a bond with a fixed interest rate, while the floating cash flows can be considered equivalent to a floating rate note. Therefore, a swap’s duration is approximately the duration of a fixed rate note minus that of a floating rate note. Furthermore, a typical swap involves no exchange of principal, as the fixed and floating principal payments offset at both the start and maturity of the swap. Bottom line—a swap is a relatively easy way to add duration to or subtract duration from a portfolio.
Who uses them
Swaps are used by banks, mortgage servicers, bond issuers and investors. Banks and mortgage servicers typically employ interest rate swaps to manage their asset / liability gaps, while bond issuers and investors will use swaps to modify the economics of a bond issue or hedge interest rate risk for an upcoming bond issue or cash flow. For example, after a corporation has determined it would like to issue a bond, it can pay the fixed rate on a swap (similar to shorting a bond) to hedge the risk of rates increasing prior to the issue coming to market.
Prior to the credit crisis, swap spreads were assumed to have similar characteristics to bank credit spreads. Since a counterparty would execute swaps with a bank, swap spreads should reflect the credit of banks as a whole. As the credit crisis took hold, however, liquidity concerns were of primary importance and as credit spreads in general widened, swap spreads compressed. For example, in the U.K. and U.S. long-dated swap spreads dropped to negative territory as pension funds received the fixed rate in swaps in order to manage their duration exposure. In the early stages of the crisis, corporate bonds were not purchased since cash was not accessible for many investment managers.
Downward spiral
In Canada, other factors were driving swap spreads narrower, including management of asset/liability gaps and mortgage-related hedging. As opposed to the U.S. where 30-year mortgages are not uncommon, most mortgage related swap transactions occur in the 5-year and under maturities in Canada. Therefore, 2-year swap spreads in Canada were negative for the early part of 2009 until market conditions normalized. It is unlikely that short end swap spreads will repeat this feat, though it would not be surprising to see long dated swap spreads in Canada turn negative once again as pension funds turn to the swap market for long-dated duration.
When one asks a market professional why an asset has a particular price, the cynical answer is usually “supply and demand”. In fact, this is exactly what has driven swap spreads to negative levels but the reasons have changed. In the early days of the financial crisis, liquidity and demand for duration drove spreads to low or negative levels. Recently, concern over the supply of government bonds is driving spreads even lower. Since the excesses of the private sector have been transferred to the public sector and Western countries are running record deficits, sovereign credit spreads and expected issuance have also increased. The concern with negative swap spreads is that it may not be temporary. A logical extension of this reasoning would suggest that risk managers consider the possibility of negative corporate spreads for select international high-grade credit.