Negative Swap Spreads and What They Really Mean

If you haven’t heard, there’s a lot of buzz going on in the debt markets these days around the fact that something very strange is going on: interest rate swap rates are lower than their US Treasury counterparts. Huh?

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. We’re offering an opportunity to understand what negative swap spreads are and what they mean for you.

What’s a swap spread?

Swap Spread Definition: The additional interest a AA rated financial institution pays over the US government to borrow money. In other words, the cost of funds for a bank with a high credit rating.

Logically, a bank should pay MORE than the US government to borrow, and in most normal market environments, this is the case. 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. Keep in mind the government is the banks guarantor. To place a higher risk premium on the US government than on a bank is a contradiction in terms and makes no sense. It also is a symptom of deeper problems in debt markets.

So why are Swap Spreads Negative?

Swap spreads have been negative on the long end of the interest rate curve (e.g. 30 years) for years. It was only recently that they became negative for 10 year maturities, and hedgers began to take notice. The swiftness of the erosion in spreads is noteworthy and has occurred across the entire swap curve, with even 2-year maturities flirting with negativity.

There are several factors acting together that are causing swap spreads to be negative. Check it out:

Corporations are piling into the debt markets by issuing fixed rate bonds to take advantage of low borrowing costs: Much of the proceeds of record corporate debt issuance have been used to finance stock buybacks. When they issue fixed rate debt, these companies typically swap their fixed rate debt obligations to floating ones. The more corporates that swap from fixed to floating, the lower the swap spread.

Unintended Consequences of the Post-Crises Bank Regulation: This is by far the most popular explanation. 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. These higher costs have curtailed bank market-making in bonds – as they face limited resources and a more stringent and costly regulatory environment – reducing liquidity and driving repurchase agreement rates (“repo” rates) higher than bank’s cost of funds. Repo rates are considered the cost of financing positions in government debt and factor directly into US Treasury yields. Let’s review:

Higher repo rates = higher Treasury yields
Higher Treasury yields + lower swap rates = narrower or even negative swap spreads over time

Rebalancing of Debt Holdings by Global Central Banks: China and even the Fed, due to the end of QE, are no longer buying Treasuries as they once were. This drives Treasury yields higher as a lack of buyers/more sellers drive their price lower, and thus also contribute to narrowing swap spreads.

Broken Global Financial Markets: Normally one sees tight swap spreads when governments are issuing unusually high levels of debt (which they aren’t) or if bank credit quality is perceived to be very strong (which it isn’t).

The nonsensical nature of a negative swap spread is what some are calling evidence of malfunction if not distress in global financial markets, a distress that is hidden behind the feel-good headlines of rising equity markets and forecasts of looming Fed interest rate hikes (ours included).

So why Should I care?

Let’s put it all together now – here’s the cycle: Interest rates near all-time lows encourage corporations to borrow, in the form of publicly-issued, fixed interest rate bonds. A large portion of these bonds are swapped to floating interest rates, pressuring swap rates lower. 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. This has reduced liquidity in the debt markets while pushing Treasury yields higher. Again, Treasury yields higher + Swap rates lower = narrower swap spreads.

One can draw two possible conclusions:

Negative swap spreads are a market anomaly, will correct themselves eventually and will have limited impact on hedgers in the interim, OR

Negative swap spreads are a sign of a deeper problem. The increasing likelihood of a Fed hike is causing many to conclude that corporate’s borrowing binge, and hence buybacks, will slow, placing downward pressure on equity prices. With this issue debt/stock buyback activity stripped away, some say that that the dismal state of cash flows of large US corporates will be laid bare, placing even more downward pressure on equities. Consumer confidence and the generally accepted view of the “steady as she goes” belief in the state of US economic growth could then be shaken. With an economic expansion that’s in its sixth year, a growing sense of a coming recession is mounting, and the factors above strengthen the case for one sooner rather than later.

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