Swap Spreads For Dummies?

November 21, 2015

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I inspired this article. Seriously. I think that makes me a dummy. But anyway, negative swap spreads have been a hot topic lately but to understand them, first you have to understand swaps, and then swap spreads and then negative swap spreads.

Some definitions to get started:

Swap: A derivative contract through which two parties exchange financial instruments. Most swaps involve cash flows based on an agreed notional principal amount. Each cash flow comprises one leg of the swap. One leg is generally fixed and the other is variable (Investopedia).

Swap rate: The rate of the fixed portion of a swap which will be the rate for one of the parties (Investopedia).

A swap spread is the difference between the swap rate (the fixed rate) and the lending rate offered through other investment vehicles (e.g. Treasuries).

Negative swap spreads: Model Capital Management explains, "Swap spread turned negative, meaning that swap rates [the fixed rates] have dipped below yields on corresponding U.S. Treasuries."… Typically, swap rates are higher than the corresponding Treasury yields, corresponding to positive swap spreads, "because Treasuries are obligations of the U.S. government – as close to a risk-free rate as we can get, while swaps are contracts with investment banks and involve 'counterparty' risk." Thus when swap spreads are negative, the fixed rates are less than the Treasury rates.

Now that the terms are all clear, let's start the lesson…

Swap Spreads For Dummies?

By The Nattering Naybob (originally published at Seeking Alpha)

Summary

Discussion of negative swap spreads and liquidity implications on capital and asset markets.
Examination of influences on the swap spread "pool."
Examination of bond vs. swap instrument structure.
Discussion of the nature of swap spreads, scope and scale of the "pool."
Insight investors might gain from a discussion of a complicated macroeconomic issue.

Excerpt

Swap Spreads Turn Negative, Implications?

Swap spreads approximate the difference between the yields on U.S. Treasuries and the interest rates on dollar swap contracts which are commonly misconstrued as a gauge or proxy for the borrowing costs of top U.S. banks. Some asset managers have entered into swap contracts to receive fixed-rate cash flows to hedge on the corporate bonds they either issue or purchase. Is this what really pushed swap rates below Treasuries yields? Or is there more than meets the eye?

Bloomberg writes of negative swap spreads indicating "debt market distortions," but its discussion lacks anything conclusive as to the cause.

"Everybody in the fixed-income market should care about this… Traditional pricing and relative-value rules are breaking down… As the phenomenon becomes more widespread, it adds to evidence that it's not just a one-off, Moves in spreads should be viewed as symptomatic of deeper problems… What there doesn't appear to be is any single smoking gun that says why swap spread changes have been so dramatic… something bigger brewing under the surface that so far hasn't been pinpointed yet."

Swap rates are fixed rates charged as a part of interest rate swaps — derivative contracts to exchange fixed interest payments (based upon longer-duration holdings) for floating rate payments, typically based on principal plus LIBOR. When a swap spread turns negative, this means swap rates have dipped below yields on corresponding duration USTs.

Full article here >

Swap Spreads For Dummies? is part of an online course in Macro Economics called Market Forces 101. The Nattering One warns readers, "Reading not only those listed below, but also every installment of these multi-part missives could lead to a better understanding of the market forces in play and how to profit from them." Here's the syllabus: