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A swap spread is the difference between the fixed component of a given swap and the yield on a government security, usually from the U.S. Treasury, with the same maturity. Swaps are derivative contracts to exchange fixed interest payments for floating rate payments. Since a Treasury bond (T-bond) is often used as a benchmark and its rate is considered risk-free, the swap spread on a given contract is determined by the perceived risk of the parties engaging in the swap. As perceived risk increases, so does the swap spread. For this reason, swap spreads can be used to assess the parties’ creditworthiness.
Key Takeaways
- A swap spread is the difference between the fixed component of a swap and the yield on a sovereign debt security with the same maturity.
- Swap spreads are used as economic indicators. Higher swap spreads are indicative of greater aversion to risk in the market.
- In a notorious example, liquidity was greatly reduced, and 30-year swap spreads turned negative during the financial crisis of 2008.
How a Swap Spread Works
Swaps are contracts that allow people to manage their risk, and two parties agree to exchange cash flows between a fixed and a floating rate holding. Generally speaking, the parties receiving the fixed rate flows in swaps increase their risk of rising rates.
However, if rates fall, there is the risk that the original owner of the fixed rate flows will renege on the promise to pay that fixed rate. To compensate for this, the receiver of the fixed rate requires a fee on top of the fixed rate flows. This is the swap spread.
The greater the risk that the promise to pay will be broken, the higher the swap spread.
Swap spreads correspond closely with credit spreads and reflect the perception that swap counterparties will fail to make their payments. Large corporations and governments use swap spreads to fund their operations. Typically, private entities pay more or have positive swap spreads than the U.S. government.
Swap Spreads as an Economic Indicator
Swap spreads are influenced by the overall supply and demand in the market. They gauge the market’s interest in hedging risk, the cost of such hedges, and the overall liquidity in the market. In essence, swap spreads reflect the market’s collective sentiment regarding risk management, cost of protection, and the ability to trade financial instruments.
The more people want to swap out of their risk exposure, the more they must be willing to pay others to accept that risk. Therefore, larger swap spreads indicate a higher overall level of risk aversion in the marketplace. Thus, it can help gauge systemic risk.
When there is an increase in the desire to reduce risk, spreads widen significantly. This can also signal a vast reduction in liquidity, as was the case during the financial crisis of 2008.
Negative Swap Spreads
The swap spreads on 30-year T-Bonds turned negative in 2008 and have remained there since. The spread on 10-year T-Bonds also fell into negative territory in late 2015 after the Chinese government sold U.S. Treasurys to loosen restrictions on the reserve ratios for its domestic banks.
The negative rates could imply that the markets view U.S. government bonds as risky after the prior bailouts of private banks and T-bond sell-offs in the aftermath of 2008. But that wouldn’t explain the enduring popularity of other T-bonds of shorter duration, such as two-year Treasurys. Another explanation for the 30-year negative rate is that traders have reduced their holdings of long-term interest-rate assets and, therefore, require less compensation for exposure to fixed-term swap rates.
Still, other research indicates that the cost of entering a trade to widen swap spreads increased because of higher regulatory leverage requirements. The return on equity has consequently decreased. The result is a decrease in the number of participants willing to enter such transactions.
Example of a Swap Spread
If a 10-year swap has a fixed rate of 4% and a 10-year T-note with the same maturity date has a fixed rate of 3%, the swap spread would be 1% or 100 basis points: 4% – 3% = 1%.
Why Are Swap Spreads Important?
Swap spreads indicate credit risk associated with a swap. A wider spread suggests greater risk compared with a specified government bond.
Who Uses Swap Spreads?
Large companies, financial institutions, investors, and traders use swap spreads to evaluate risk and return in the bond and derivatives markets.
Can Swap Spreads Predict A Recession?
A widening swap spread indicates increasing credit risk associated with swaps on government bonds. It can also suggest higher demand for swaps or reduced demand for government bonds. A significant widening of swap spreads could signal increased uncertainty or perceived credit risk in the market, which can be seen preceding economic downturns. However, one should deal with them cautiously to predict macroeconomic changes since they can be affected by technical factors irrelevant to broader economic conditions.
The Bottom Line
Swap spreads play a critical role in the financial markets, providing insight into credit risk and liquidity conditions, reflecting the market’s perception of risk, and influencing investment decisions and monetary policy. Factors affecting swap spreads include the perceived creditworthiness of counterparties, market liquidity, and supply and demand dynamics in the bond and swap markets. Changes in these can cause swap spreads to fluctuate, impacting the cost of borrowing and the return on investment for diverse financial instruments. Therefore, understanding swap spreads is crucial for investors, financial institutions, and policymakers.