In
finance, swap spread is a standard method to specify the credit spreads in a
market. It is the difference between the agreed and fixed rate of a swap. The
spread is influenced by aspects of market supply and creditor value.
Firms
engage in swaps to benefit from an exchange of relative interest rate gain. The
terms of a normal swap (plain vanilla) vary extremely from contract to contract
on the basis of the requirements and the availability of resources to the
contributing counterparties.
Normally,
a Treasury bond is used as a benchmark since its rate is considered risk-free.
The swap spread on a particular contract reflects the related level of risk.
There would be an increase in risk as the spread widens.
In the US
market, financial stakeholders and investors have had to deal with a scenario
of extremely negative swap spreads during the last six months. Intraday
fluctuations and huge swings in the form of the swap spread curve continue to
deliver a challenging environment for issuers and investors to overcome.
Swap
spreads have been the key area of focus in the sovereign, supranational and
agency (SSA) market due to their significant tightening (levels and
volatility). While we have moved away from the worst of the negative levels
witnessed during the end of 2015, it seems the negative swap spreads –
particularly five years and more are here to stay.
According to market experts, there
are two critical drivers behind the moves:
Structural Factors
Stringent
regulation has increased the balance sheet cost and made cash products less
expensive in comparison to the derivative products.
There has
been an acceptance of the increasing cost of balance sheet over the last one
year as traders and banks have had to adjust to a post-leverage ratio
environment.
This has
reduced the correlation between Treasuries (on-balance sheet assets) and swaps
(off-balance sheets).
The market
activities can be explained by an increasing cost of balance sheet because of
the Supplementary Leverage Ratio (SLR) and the impending Net Stable Funding
Ratio procedures (finalized procedures expected in 2016).
The repo
market is connected to the cost of the balance sheet and therefore, must face
the impact of new guidelines.
Repo
balances have contracted by 20% since Q2 2013 when SLR was declared. The SLR
guidelines are mandatory for most banks in the US and Europe and
disproportionately affected repo and Treasuries, which earlier benefited from
zero risk weighting.
Spreads
would remain in a tighter range in comparison than past levels would indicate
due to structural reasons. However, within the tighter range, spreads could
vary on the basis of issuance /hedging requirements.
Temporary Factor
They are
driven by trends in reserve manager flows, corporate issuance or hedging
requirements of insurance firms.
Central
bank reserves have been reducing gradually over a period of one year, with the
pace of the weakening accelerating severely during the last quarter of 2015 as
the market started to adjust to forthcoming rate hikes and a robust dollar.
This led to a substantial amount of Treasury selling by international central
banks, as proven by the increase in the primary dealer inventories.
Traders inability
to remove Treasuries from their balance sheets amidst robust selling flows by
international central banks resulted in lowering of Treasuries in comparison to
other assets, including swaps.
An increase
in corporate bond and SSA issuance is frequently complemented by increased
delivery of fixed rates since issuers swap fixed rate debt to floating.
Normally,
January, March, and September denote mega issuance months and are frequently
complemented by a tightening in spreads.
A huge
volume of issuance in January 2016 assisted drive spreads tighter in early
January, but the following slowdown in issuance amidst an increase in market
instability assisted push spreads wider.
Another
reason that has driven spreads tighter and the spread curve flatter has been
variable annuity hedging, which complements lower levels in equities (For e.g.
January-February 2016).
VA
liabilities expand in duration, forming huge receiving requirements when risk
assets decline severely.
Consequences for SSA issuers and
investors
In recent
weeks, there has been a significant widening in swap spreads in the short end
of the curve because of the widening in the Libor-OIS relationship, while swap
spreads in the long end have continued unaffected.
At
present, two-year swaps are at +14bps and 10-year swap spreads are at -13 bps.
This would flatten the credit curve on a spread to USTs (The United States
Treasury).
This means
that investors are being forced to modify their assessments regarding the value
on a spread to USTs and that credit curves are expected to stay flat.
In the
near-future, spreads could be near to the wider end of the recent range,
particularly in the short end, assisted by the recovery in equities and an
expected slowdown in the pace of corporate issuance.
The five years’
spreads would be around 0bp and -5bp, while the 10 year spreads would be in the
range of -10bp and -15bp in the coming months. There would be some tightening
during September 2016.