Why Are Swap Rates Trading Below U.S. Treasury Rates?

What’s the Opportunity for You?

Tina Hwang, Managing Director, PNC’s Derivative Products Group
Vickie DeTorre, Managing Director, PNC’s Derivative Products Group

Historically, interest rate swap (swap) rates[1] have been higher than the essentially risk-free U.S. Treasury securities (Treasuries) of the same maturity. The difference between the two rates is known as the swap spread. Swap spreads represent the incremental funding cost for financial institutions, and more broadly represent the credit spread over the corresponding benchmark U.S. Treasury for interbank lending.

The regulatory requirement for central clearing of most interest rate swaps (except for swaps with commercial end users) has removed counterparty risk from swap contracts.

Historically, swap spreads have been positive with the exception of the 30-year term and during periodic market disruptions. In September 2015, the 10-year swap spread turned negative, and today, all swap spreads with a tenor of 5 years and greater are negative. In theory, this implies that the financial strength of banks is greater than that of the U.S. government and that the funding costs of banks are lower than the U.S. Treasury. However, in practice, that has not been the case for term borrowings. This phenomenon of negative swap spreads may provide end users the ability to borrow floating and pay fixed on swaps, thereby obtaining a comparative advantage in funding costs.

PNC’s Derivative Products Group (DPG) has been fielding questions from our clients and relationship managers asking why negative swap spreads are continuing and the impact it may have on market participants. This article is an effort to provide that explanation.

Why are Swap Spreads Negative?

Following the financial crisis and the failure of Lehman Brothers, swap contracts were reevaluated based on the viability of counterparties. Swap rates for the over-the-counter (non-cleared) swaps market experienced tremendous volatility. Swap spreads in general widened as market participants put premiums on counterparty risk. But in the latter half of 2008, the 30-year swap spread dropped and quickly turned negative. Many market events contributed to the 30-year spread remaining below zero without significant fanfare. It wasn’t until last September when the 10-year swap spread decidedly dipped below zero that many turned their attention towards the swap spreads market. This downward movement by the more popular 10-year swap rate has been slowly occurring and is a result of a structural change in the marketplace.

In a surprise move in August 2015, the People’s Bank of China (PBoC) cut its benchmark lending rate and reserve ratio requirements to spur growth as it transitions from a manufacturing economy to a service economy. To support its declining currency, the Chinese central bank sold U.S. Treasuries. With prices of Treasuries moving lower and yields moving higher, swap spreads narrowed. As a result, the 10-year swap spread moved negative. In addition to the PBoC, a number of other foreign central banks have sold U.S. Treasuries in an attempt to support their currencies. The large outflow of foreign exchange (FX) reserves put Treasuries under pressure versus swaps, thus narrowing the swap spread. During this period, dealer treasury holdings increased to four times the average.

As central banks sell U.S. Treasuries, primary dealers have increased their holdings of U.S. Treasuries. Treasuries are funded assets, and dealers take inventory and finance their holdings at repo rates by using short-term repurchase agreements. Repo rates have risen much faster than other short term borrowing rates (including LIBOR) due to the rise in demand. A jump in repo rates versus LIBOR has narrowed swap spreads.

Another factor contributing to the narrowing of swap spreads is mortgage-related paying. A fundamental driver of support for swap spreads has abated as Government Sponsored Enterprises (i.e., Fannie Mae, Freddie Mac) portfolios have decreased in size. In addition, the Federal Reserve Bank, which does not hedge its portfolio, is the single largest holder of agency mortgage-backed securities.

Today, mortgage hedgers are much less active, removing an important source of pay-fixed swap demand from the market.

The continued strong sales of corporate bonds by issuers has also contributed to negative swap spreads. With corporations holding large amounts of cash on their balance sheets, companies are swapping their fixed rate bond issuances back to floating rates through an interest rate swap under which companies receive fixed rates and pay floating rates (usually LIBOR). This puts downward pressure on swap rates and thus swap spreads. This has allowed companies to lock in long term liquidity and pay a floating rate on their debt. The floating rate risk is somewhat mitigated by the floating rate of interest received on cash.

Perhaps the most notable reason for negative swap spreads has been regulation. The regulatory requirement for central clearing of most interest rate swaps (except for swaps with commercial end users) has removed counterparty risk from such swap contracts. Regulatory hedging costs and balance sheet constraints have also come into effect over the past few years. These rules have significantly reduced the market-making activity of swap dealers and increased the cost of leverage for such dealers. This is evidenced in the repo rates versus the Overnight Interest Swap[2] (OIS) basis widening. This basis widening strips rate expectations (OIS) from the pure funding premium (repo) rates. Swaps and Treasuries are less connected than in the past. The spread between them is a reflection of the relative demand for securities, which need to be financed, versus derivatives, which do not.

Expectations and Market Opportunities

Going forward, we expect the negative swap spreads to stabilize with the bias toward moving wider (less negative). Some of the factors that contribute to this include the slowing of U.S. Treasury sales coming out of China. Data released recently showed that China’s FX reserves increased for the first time since last October. An additional factor for this has been the significant decline in net primary dealer positions in U.S. Treasuries, which has typically spiked during periods in which Chinese reserves were declining. Therefore, the demand for Treasuries from foreign accounts seeking yield, coupled with a reduction in sales from China, should support cash yields versus swaps. Additionally, recent softness in repo rates has pushed the spread to LIBOR to its widest level since year-end. Lastly, with the current low level of interest rates, there hasn’t been a strong desire for bond issuers to hedge, reducing the demand for issuance-related, receive-fixed swaps. All of these factors would have the effect of pushing swap spreads wider (less negative) from their current levels.

Current negative swap spreads present an opportunity for market participants favoring fixed rate debt. The bank markets traditionally price over LIBOR, and the bond markets price over Treasuries. By electing to pay a fixed swap rate, a market participant enjoys the benefit of negative swap spreads through a lower swap rate paid for the life of the contract. Conditions are such that accessing the bank market on a floating rate basis and paying a fixed swap rate may present a lower rate than the bond markets.

 

ABOUT THE AUTHORS

Tina Hwang, Senior Vice President, Managing Director, PNC’s Derivative Products Group — Tina Hwang is a Senior Vice President and Managing Director of PNC Capital Markets. In her position, she serves as regional manager for the northeast and mid-Atlantic territories for PNC’s Derivative Products group. Hwang and her teams in Philadelphia, Washington, D.C. and Baltimore address the risk management needs of PNC Bank’s customers, working collaboratively to properly identify, structure and execute interest rate and currency swaps across multiple lines of business. She has more than 28 years of experience in the financial industry. Prior to joining PNC, she worked for a number of major banks and securities companies, specializing in derivatives and other financial products. She has lived in Seoul, Korea and Osaka, Japan and currently lives in Media, Pa. She holds bachelor of arts degrees in economics and East Asian studies from Dickinson College. She is a member of the local chapter of the PNC Foundation, and a board member of Elwyn Corporation, a nonprofit organization that serves the needs of individuals with disabilities.

Vickie DeTorre, Managing Director, PNC’s Derivative Products Group — Vickie DeTorre is primarily responsible for managing PNC’s customer derivatives portfolio, which includes pricing and executing various derivative transactions and managing the risks associated with those transactions. She works closely with the derivatives sales force to develop interest rate hedging strategies for PNC’s customers. Vickie joined PNC in January 1997. Prior to joining PNC, Vickie spent eight years with the Rate Risk Management Group at another major bank. She holds a bachelor’s degree in business/accounting from the University of Pittsburgh and has obtained her Series 7 and Series 63 licenses.