We understand if you have avoided some of the more technical stories on the topic in the financial news; it’s a difficult concept to comprehend as even experienced market players have trouble understanding it, or more importantly, how the phenomena could impact the economy or future Fed decisions. Once the government started backstopping every financial institution, spreads tightened to reflect the decreased (perceived) risk. This reduces credit risk, which exerts downward pressure on swap spreads. The swap spreads on 30-year swap Treasury bonds turned negative in 2008 and has remained in negative territory since. 2012 – 10T vs 10yr Swap Spreads Just as importantly, Basel III capital requirements are measured at quarter end. T… Swap rates are fixed rates charged as part of interest rate swaps – derivative contracts to exchange fixed interest payments for floating (typically Libor). And these are not the droids you seek.” And then I would wave my hand in front of your face, you’d realize no one cares about the 30 year part of the curve, and we would go back to discussing the important details of your specific financing. “It’s highly technical. Maybe investor demand wasn’t there when you were pricing off a 2% 10T, but all of a sudden there is enough demand when you’ll be pricing off a 2.30% 10T. That’s dumb”. In a year of record issuance, there are a lot of receivers in the market. Now you are receiving a fixed rate that replicates the coupon you were receiving right before you sold the bond. One trader noted, “The best way to think about swaps vs Treasurys is to almost think of them as two separate asset classes in this environment. But unlike the banks mentioned above, central banks are owners, not hedgers.

To place a higher risk premium on the US government than on a bank is a contradiction in terms and makes no sense. Now all of a sudden you are earning 0% to appease the regulators. That’s a great question. Banks have bonds held as investments, but those tie up precious capital. So, with expectations of rising interest rates, not only institutions created large demand to pay fixed rates (which would imply higher swap rates as I explained above), but dealers also wanted to be on the same side of the trade.

Varying theories are offered, but neither seem to be plausible.

If the recent 0.30% selloff in Treasurys is to blame for negative spreads, why didn’t we see negative spreads when the 10T sold off almost 1.40%? When I asked one of our option traders why he thought spreads were negative, he said, “In one word, Regulation.” Sounds like a good starting point. Two-year swap spread turned negative, joining rest of curve, Support rooted in regulatory relief has faded into memory. The bottom line is that post-financial crises, regulation has made it more expensive for banks to make markets in bonds as higher capital requirements mandate banks to hold a larger inventory of costly bonds to provide a financial cushion in the event of financial turmoil. Until the financial crisis, swap rates -- which entail credit risk -- were higher than Treasury yields. And if so, doesn’t that suggest a greater problem? 2. That prospect was overtaken, however by demand for swaps from corporate bond issuers and hedging related to plunging yields. In the Treasury market (and in corporate bond market, and so on), yields balance the demand for government bond investments with supply of those bonds. You enter into a receive fixed swap, that’s what you do.

Meanwhile, the combination of increased Treasury supply and waning Chinese demand has bloated dealers’ balance sheets, driving up the cost of financing positions and hurting the relative value of Treasuries versus swaps. We need to think the current environment as a confluence of events. Treasuries are issued at the federal level. If the swap spread was 10bps, then we would expect Wells to price 10yr bonds at 10T + 10bps. The large banks that take the other side of the corporate debt issuance activity are now subjected to never before seen, very expensive capital requirements (holding a greater amount of Treasuries on their balance sheets as required by regulations), so much so that they are greatly reducing or eliminating altogether their debt dealing businesses due to low profitability. If the other counterparty in your trade defaults, the exchange steps in and becomes your counterparty.

Here’s where things get interesting. Borrowers care about 10yr rates. All the traders we spoke with felt like negative spreads could persist for a while. The result is a decrease in the number of participants willing to enter such transactions. All my responses were vague trader-speak that I didn’t fully understand.

3. When corporations issue fixed rate bonds, they frequently swap them back to floating. “Swap spreads have tightened in line with our expectations driven by recession fears, central bank selling, and corporate supply,” Ruslan Bikbov, a strategist at Citigroup Inc., wrote on June 14. Let’s review: Higher repo rates = higher Treasury yields, Higher Treasury yields + lower swap rates = narrower or even negative swap spreads over time. This flow/natural paying source has been removed from the market.”. In contrast to our demand-based explanation for negative swap spreads, Jermann (2016) studies the negative swap spreads, o ering frictions for holding long-term bonds as an explanation. With the right set of circumstances, we may see spreads fluctuate from current levels to + 0.05%, but spreads will probably run out of steam at that level. While “swaps” may mean little to an average retail investor, they are very common among institutional fixed-income investment managers (think Pimco, BlackRock, life insurance companies). Gear, equipment, weapons, room […]. Corporate bond issuance has already broken the record for most in a year and we still have 6 weeks left in the year. But why didn’t swap spreads go negative during the Taper Tantrum when the T10 jumped more than a point in a month? Liquidity was greatly reduced and … Higher swap spreads are indicative of greater risk aversion in the marketplace. A swap curve identifies the relationship between swap rates at varying maturities. In late 2008, 30-year swap spreads turned negative. h��S�Ka޻ۼ��nnfi�nn�4wK&�r��aF��ChK[�P\b�A��ӈ(23�2BKa� El�pD�5" It caught up with the two-year sector Tuesday following indications that Chinese demand for Treasuries is ebbing amid trade hostilities. And that means she gets to pay less, if anything. The market views government as an increasingly risky counterparty. This is the swap spread. The correlation appears to be in effect prior to the Taper Tantrum, but then as the 10T sold off and spiked more than 1.00% in a month, why didn’t spreads collapse? Over the past two years, swap spreads have generally tightened, which is to say the difference between Treasury yields and swap rates has declined. Dodd-Frank – you probably know DF as that cumbersome registration process prior to executing a trade, but that is just a small portion of the regulation. All rights reserved. We’re offering an opportunity to understand what negative swap spreads are and what they mean for you. However, over the last couple of months the 10-year “cost of money” for a AA rated bank was actually LOWER than that of the US government, an entity that is guaranteed to repay its debt and carries the highest credit rating. As rates were going haywire and the FOMC met and the job report shocked the world, etc I just couldn’t dig in and they didn’t want to be bothered. Swap spreads correlate closely with credit spreads as they reflect perceived risk that swap counterparties will fail to make their payments. It is also a gauge of systemic risk. This explains why front-end swap spreads are still in positive territory.

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