UNDERSTANDING THE US SWAP SPREAD

The bond swap spread is the difference between the swap rate and the Treasury yield. The swap rate is the rate that a trader pays to exchange a fixed interest rate for the floating rate. For instance, if a trader views that the rate is moving up, he may choose to pay a fixed rate and receive a floating rate, which is often the three-month Libor rate. In order to fully understand the bond swap rate, we need to understand swap transactions from the bond’s point of view. Assuming that the investor has no cash on hand but would like to invest in 10-year bonds, he can choose to borrow money for three months and then buy 10-year US Treasuries. If he can borrow at the three-month Libor rate of 0.3240% and the 10-year US Treasury yield is 2.03%, throughout the 10-year term the investor would receive the fixed rate of 2.03% and would pay the three-month Libor floating rate of 0.3240% for the first three month period. The case is very similar to the situation whereby an investor enters into a 10-year swap agreement to receive the fixed rate at the market rate of 2.02% and pay three-month Libor floating rate. As of Oct 1, the 10-year swap spread is quoted at -0.01%, which is the difference between the swap rate (2.02%) and the bond yield (2.03%). In theory, the swap rate should be higher than the bond rate because the swap counterparty has credit risk. To illustrate, when buying US Treasuries, investors assume there is no credit risk as the bond is backed by the full faith and credit of the US government. However, when investors receive the fixed rate from a swap contract, they take the risk that the counterparty might default and not honour the swap contract. As discussed in the example above, currently the swap rate is now lower than Treasury yield, or, in other words the spread is trading at almost zero to negative territory. We will continue the article next week to discuss what may potentially cause the swap rate to trade very close to or even lower than the bond rate in the current environment.

Skul Boondiskulchok, CFA, is an assistant vice-president in Bangkok Bank’s Treasury Division.