Courtesy of Rom Badilla, CFA – Bond Trader
Many people including mainstream media are scratching their heads on today’s action as the yield on 10-year interest rate swaps traded well below the yield on 10-year U.S. Treasuries.
10yr Swap Yields Are Not Supposed to be Lower than Treasuries!
Theoretically, such a dynamic should not happen since Treasuries are backed by the safest creditor in the world while entering into an interest rate swap agreement subjects an investor to credit risk stemming from the counterparty, such as a bank or financial entity. Such risk should command incremental return to the investor in the form of higher yield and thus a positive spread between the riskier swap and the risk free Treasury. This was not the case as the spread entered into negative territory for the first time in recent history.
There are three catalysts that point to this event with the first being the Federal Reserve’s latest policy statement suggesting that short term interest rates will remain low and accommodative for the foreseeable future. Essentially, the Fed will keep the Fed Funds rate at current levels until improvement in the country’s unemployment rate and as long as inflation remains subdued. The second is the waning demand for U.S. Treasuries as evident by today’s auction and increasing risk for sovereign debt such as Greece and Portugal, which was downgraded by Moody’s today to AA-. Each fact points to higher yields. The third catalyst is the impending amount of corporate debt issuance.
The best way to illustrate this is to analyze it is from the perspective of a corporation that is looking to issue debt and minimize the subsequent interest expense. This can be done particularly in this rate environment by issuing out floating rate debt, which closely tracks short-term rates like the Fed Funds rate. Since the Fed Funds rate should remain low and anchored due to the aforementioned reasons, this is ideal for a corporation. However, investors who are trying to maximize returns prefer to receive a higher set or fixed coupon that will closely resemble the 10-year note (plus credit spread commensurate with the corporation).
In order to bridge this gap of needs, a corporation will cater to investors by issuing debt with a higher fixed coupon. Unfortunately, with longer maturity yields tracking higher due to the aforementioned reasons of the weak Treasury auction and the increasing sovereign risk, this is far from ideal for the corporation. This can be circumvented by entering into an interest rate swap agreement with a counterparty, such as a bank.
The swap agreement will allow the corporation to receive a fixed rate from the bank, which will offset the fixed rate amount paid to investors on the debt, in exchange for paying a floating rate to the bank. In essence, by entering into a swap agreement, a corporation is able to reach its goal of issuing debt and minimizing interest expense.
So going back to today’s environment where on the horizon, large amounts of corporate debt issuance is hitting the market with not enough counterparties to offer swap agreements, the price increases (in the form of declining yield on the interest rate swap) due to higher demand and insufficient supply. This market imbalance is the reason why swap spreads on the longer end of the curve turned negative and counter to market theory.
While it is difficult to gauge how long this imbalance will persist, I do think that 10-year swap spreads will revert to its proper relationship. I think that if the corporate calendar finds a respite and if market volatility spikes (VIX jumped 7.3 percent today) due increasing sovereign risk, equity weakness, mounting Treasury supply, or some combination, swap spreads could widen back into positive territory where it belongs.
Disclaimer
The above content is provided for educational and informational purposes only, does not constitute a recommendation to enter in any securities transactions or to engage in any of the investment strategies presented in such content, and does not represent the opinions of iTB Securities LLC or its employees.
Posted by John Adams on 
Market Summary and Insights: Week ended March 26, 2010
Courtesy of Reva Capital Markets LLC
Summary:
Rates increased amid swap spread capitulation trades and concerns about Treasury supply, with lackluster demand at the Treasury auctions. Relief on the Greece front, with EU member nations agreeing to backstop Greece, in case IMF and other sources are not enough. In agency MBS, clarity about the order of buyouts is finally bringing some stability to the roll markets. The Fed ends its MBS purchase program this week, and we don’t see any immediate effect due to large shorts in the sector from money managers. The administration announced changes to the HAMP modification plan (similar to a Bank of America program announced earlier last week), along with a new FHA program last week. CMBS spreads rallied in the subordinate AAAs in cash and AJ tranches in CMBX. Legacy TALF ended, though with 19 rejected bonds, the highest so far. The focus for this early-close week should be on the payroll report on Friday.
Economy:
Rates:
Thought for the Week
Stable and low interest rates fueled much of the rally in risky assets last year. There were many factors that contributed to the stability in the rates market- involvement of the Fed as an enormous duration buyer, strong overseas demand for US Treasuries and money flow from money-market funds. Did the lackluster demand for Treasury auctions last week signal an end to this dynamic? Does this portend reversal in the risky asset trade? We don’t believe that it is the case since the increase in rates last week had much to do with the technical situation with swap spreads. Swap spread wideners had been the trade du jour for the past few months as most models reflected swap spreads to be too tight given fundamentals of low rates, vol and credit/MBS spreads. Note that most models don’t incorporate a measure of Treasury supply or debt/GDP measures which is the primary reason why swap spreads should structurally be tighter. As swap spreads continued to drift lower, people began unwinding their spread wideners this week, which led to a sell-off in rates. The Treasury auctions just came at a time, when the street was long paper and that was the result for the poor performance. While we believe that swap spreads should be tighter than historicals, with clear positions the rates market should see some more stability and potentially catch a bid from banks that can now own Libor positive zero risk weighted assets.