Swap Spread

It is the difference between the fixed aspect of a particular swap and a related sovereign debt security's yield with the same maturity.

A swap spread is a difference between the fixed aspect of a particular swap and a related sovereign debt security's yield with the same maturity. In the United States, the latter is a treasury bill issued by the government.

Before delving into the world of swap rates, let us briefly refresh your memory on what a swap is.

A swap is a derivative contract that allows two parties to exchange a distinct financial instrument's liabilities or cash flows for another. 

Since swaps are not traded on exchanges, they are mostly bought and sold by businesses or financial institutions in over-the-counter contracts.

Now, of the two instruments being exchanged, one has a fixed cash flow, and the other has a variable one. 

When calculating the swap rate, we consider the fixed cash flow.

Formula

Since treasury bills are essentially risk-free financial instruments, the spread on a particular contract is determined by the perceived risk of the agents involved in the transaction.

Perceived risk shares a direct relationship with the swap spread.

  • As the perceived risk rises, the swap spread increases.
  • As the perceived risk falls, the swap spread decreases.

This direct relationship allows parties to determine the creditworthiness of their counterpart through the swap spread.

Key Drivers of Spreads

In general, three components make up the difference between swap rates and government bond yields

1. Bank credit: 

This is the difference between the fixed component of an interest rate swap and a corresponding risk-free rate, such as a treasury bill. Typically, banks borrow at a rate higher than the risk-free rate.

Bank credit is pro-cyclical, i.e., it increases during bad economic conditions and reduces during good financial conditions.

2. Bond Premium: 

This is the difference between the bond rate and the corresponding risk-free rate. 

When demand for bonds is high, the bond premium tends to be lower. On the other hand, when there is a low demand for bonds, the bond premium is more significant.

3. Basis: 

This is the difference between bonds and bond futures

It is essentially a mix of the repo-forward (difference between current bond yields & the forward rate for which an investor is indifferent between buying now/later) & the bond-basket basis (difference between repo-forwards & bond future yield). 

Over the past few years, basis has been the least significant factor affecting these spreads because it is relatively small.

What Does it Do?

Consider an interest rate swap. These swaps have a higher level of credit risk than safe government bonds, so these can be seen as compensation for taking on this increased risk.

In other words, these instruments allow the transacting parties to manage their risk.

Suppose interest rates increase while the swap is still in effect. In that case, the party receiving the fixed interest rate incurs a loss, whereas the party receiving the variable interest rate makes a profit. We will consider an example in the next section to better understand this.

The fixed-rate receiver requests a charge in addition to fixed-rate flows to cover these risks. This is where the spread comes in.

They are similar to credit spreads in that they reflect the perceived risk of the other party defaulting on the agreed contract.

A well-defined interest rate swap contract clearly states parameters such as the start date, interest rates paid by either party, payment terms (quarterly, annually, etc.), and maturity date. In addition, both parties must abide by the conditions of the agreement until the contract matures.

Theoretical Examples

Let us now look at an example to understand better how these work.

Consider a 10-year swap with a fixed rate of 5% and a 10-year treasury bill with a fixed rate of 2%. For this example, we assume that the treasury bill has the same maturity date as the swap.

We know from previous sections that the formula for calculating the spread is simply the difference between the swap's fixed rate and the treasury bill yield.

Then, in this case, it is

5% - 2% = 3%

In other words, it is 3% or 300 basis points.

To solidify our understanding, let us consider another example. Before you look at the answer, try solving it yourself!

Suppose the fixed rate of a 7-year swap is 4%, and that of a 7-year treasury bill is 3.25%. What would the swap spread be in this case?

Again, we calculate the difference between the fixed rate and the treasury bill yield.

Thus, it is

4% - 3.25% = 0.75%

Therefore, it is 0.75% or 75 basis points.

Swap Spreads and The Economy

As discussed previously, swaps are a means of hedging risk. Swap spreads indicate the desire of two economic agents to hedge risk, the cost of the hedge, and the overall liquidity in the market.

As postulated by the economic model of supply and demand, the greater the need for swaps, the higher their price will be.

Thus, the greater the number of agents wishing to hedge risk, the higher they must be willing to pay to induce the counterparty to accept that risk.

This implies that a more extensive spread (the fixed rate is much higher than the government bond yield) signals a higher market risk aversion. As a result, few agents are willing to accept the high risk accompanying the swap.

Additionally, it indicates that liquidity has significantly decreased, as it did during the 2008 financial crisis.

It also serves as an indicator of systemic risk within institutions or the economy as a whole. 

Systemic risk is the possibility that the entire financial system or market will fail. It can be catastrophic, so gauging the likelihood of this risk is essential for any industry or institution.

Negative Swap Spreads

So far, the swap spreads we have looked at have been favorable. However, they may likely be harmful.

The swap spreads on 30-year treasury bills have been negative since 2008.

The Chinese government sold US treasuries in late 2015 to ease restrictions on reserve requirements for its local banks, which caused the spread of 10-year T-bonds to become harmful.

But what does this negative rate mean? For starters, it could mean that the market considers its bonds risky assets. This is especially true after the 2008 financial crisis when private banks were bailed out and treasury bonds sold off.

However, the above reasoning does not explain the popularity of treasury bills with a shorter maturity time, such as two years.

Another explanation could be that trading firms have started holding fewer long-term fixed-income securities. Therefore, they do not require as much compensation for their exposure to fixed-term swap rates.

Some studies also suggest that restrictions have made it much more expensive to enter a trade to increase it since the financial crisis. This has led to a decrease in the return on equity and, thus, a fall in the number of traders willing to enter such swaps.

Summary

The following section recapitulates what we have learned throughout this discussion. Mentioned below is the summary:

  • A swap spread is a difference between the fixed component of a swap and the yield on an equivalent government bond or another risk-free asset.
  • The key factors determining are bank credit, bond premium, and basis.
  • They are a reflection of perceived risk. Therefore, they are frequently used to evaluate the creditworthiness of the two transactors.
  • In this way, they also indicate the market's attitude towards risk.
  • A higher swap spread implies that the market is more risk-averse. Inversely, a lower one means that the market is more risk-tolerant.
  • They can also be harmful if the yield on the treasury bill is higher than that on the swap. There are several reasons why this may be, but the reason often cited is that government bonds are perceived to be riskier than other assets.
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Researched and authored by Rhea Bhatnagar | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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