A recent piece published by Bloomberg highlights a major change in the pricing of Interest Rate Swaps (IRSs). While these financial instruments fly under the radar of most individual investors, they play a major role in the management of large financial institutions. In an unprecedented move, the so-called “swap spreads” have turned negative in the U.S. and the U.K. The Bloomberg article goes so far as to suggest that negative swap spreads “may ultimately cause investors and borrowers to lose confidence in the bond market’s ability to correctly price risk…”
Is this fear justified? Has the bond market become dysfunctional? Here’s our point of view.
What’s an IRS?
An IRS is a derivative product. Loosely speaking, a derivative product is a contract that tries to replicate a position in the market without having to disburse a large initial investment. An IRS is a contract by which two counterparties agree to exchange payments over a fixed period of time (let’s say 5 years): one party will pay a fixed interest on the notional amount (for example 3% on $1 million) and in exchange, the other party will pay a floating interest rate, based on a standard short-term interest rate index, typically the London Interbank Offered Rate (LIBOR). The floating interest rate resets every quarter, while the fixed interest rate does not change throughout the contract’s period.
What does an IRS try to replicate?
An IRS replicates the position of an investor who takes a short-term loan (for instance, 3 months) and uses the proceeds to buy a fixed coupon bond. Each quarter, our investor will have to pay the current 3-month floating rate to the creditor and will receive a fixed interest payment from the bond issuer.
What are swap spreads?
Swap spreads are the differentials, for various terms, between the fixed rate available on the swap market and the yield on a Treasury bond. For example, if a swap has a 5-year maturity and a 3% fixed interest rate while Treasury bonds yield 2.50%, then the 5-year swap spread is 3.00% – 2.50% = 0.50%.
What information is conveyed by swap spreads and how has it changed?
Swap spreads are driven by two factors. The first is the supply and demand for swaps. For example, since the financial crisis, many pension funds have been reducing their risk by entering into transactions as receivers of the fixed rate in 30-year swaps. As a result, 30-year swap spreads have narrowed. The second factor is counterparty risk. In a swap, it is not the whole notional value that is at risk (in our example, a $1-million swap does not involve an equivalent amount at risk) but rather the profits accumulated over time and not yet settled. This value, in turn, is dependent on the losing party honouring their side of the contract. Until recently, swap spreads had to systematically be positive to compensate investors for counterparty risk.
What has changed is that regulations now require all IRSs to be traded through clearinghouses. This “frees” IRSs of counterparty risk. As a result, swap spreads are now only subject to the forces of supply and demand, which can deliver positive or negative spreads.
In our view, the fact that swap spreads have become negative is a result of their being safer than before. We disagree entirely with the view that negative swap spreads reflect a malfunctioning of the market in any way.