In the holiday shortened Easter week as the kids of financiers were on easter egg hunts to find the candy creme egg laid by their Easter bunny friends, their parents were on financial and economic information hunts to validate their butterfly trades. Come Easter Monday, religious watchers of (interest-rate) swap spreads are still watching for rates to rise from the dead to correct an imbalance that at least mathematically cannot continue to exist under old historical and theoretical frameworks – frameworks that never included the credit default swap.
There has been increasing interest and focus in financial circles about a recent phenomenon that has occurred in the US interest-rate swap and US Treasury bond markets. The swap spread (simply the difference between interest rate swap rates and US government treasury bonds yields) has narrowed to near record lows and at times even turned negative.
A negative swap spread implies that an “investor” is willing to accept a LOWER promised fixed rate of interest from a non-governmental entity (like a big bank such as Goldman Sachs, Citigroup, Bank of America, JP Morgan, Wells Fargo, Morgan Stanley, Barclays, Nomura, RBC, BNP Paribas, Credit Agricole, UBS, Credit Suisse, Deutsche Bank, Jeffries, TD Bank, Standard Chartered, SocGen or Scotiabank) than the stated fixed rate of interest on a government issued bond (like a US Treasury).
Risk-free rates and asset pricing models
While traditional adherents of the classic simplified capital asset pricing model (CAPM) who have often used US Treasury bonds to imitate the so-called “risk-free rate” may not be able to explain the possible existence of such a phenomena, the real truth may be in the details of the CAPM’s initial assumptions and the oft-loved sovereign credit default swap.
CAPM requires the user to make an an initial assumption about the risk-free rate. Popular belief (whether for specific reasons of fact or simply ease of use) has long held US Treasuries to be the closest thing to a “risk-free rate” as possible and therefore often used to benchmark the risk-free rate. The recent (recent being measured in months if not years in this case and not days) focus being given to sovereign CDS, as an important measure and hedge for the specific credit risk of an actual country’s obligations to investors, has changed the dynamic of traditional government bonds being viewed as entirely risk free.
With US government bond sovereign CDS prices at around 40 basis points now, an investor can buy a 5-year Treasury at around 2.6% and then hedge the position by buying a 5-year CDS that costs 0.4% leaving them with a net theoretically risk-free yield of 2.2%. Traditional model-based adherents of risk-free rate driven asset pricing models will want to take note as this adjustment is one way to mathematically explain the negative swap spread phenomena occurring right now in certain parts of the yield curve.
Clearly, not all investors believe the raw Treasury yield to be a true risk-free measure anymore and this has implications for the importance of looking at Sovereign CDS prices just as much as Treasury prices when trying to either theoretically price or judge implied credit risks and risk-free or hurdle rates applicable to specific countries. CDS prices may now be a very important tool to a much greater group of investors and market participants than historically believed.
Other factors in a negative swap spread
Other explanations or additional factors to consider in the existence of the current negative swap spread at some tenors include the imbalances of supply and demand for swaps relative to treasuries in the current economic environment.
As The Economist put it, another “explanation is the sheer volume of bonds being issued. These bond issuers would rather swap their fixed-rate obligations for floating-rate ones. So they have to pay a floating rate and receive a fixed one. The result is an imbalance of supply and demand: those people willing to pay the fixed-rate part of the swap can get away with a lower yield than the American government.
In Britain a similar technical oddity has led to the 30-year swap spread being negative for a considerable period already. Demand from British pension funds, which use the swap market to hedge their long-term liabilities, has forced down fixed-swap rates. What is seen as an unusual situation in the American market may become the norm.
Technicalities aside, the most plausible explanation for the steep yield curve is the interaction of monetary and fiscal policy. On the monetary side the Fed is holding short rates at historically low levels in response to the severity of the crisis. On the fiscal side America’s budget deficit has soared to over 10% of GDP, leading to heavy debt issuance. Recent Treasury-bond auctions have seen fairly weak demand, forcing yields higher.”
The quantitative impact of economic effects including monetary or fiscal policies mentioned by the magazine are evident in the prices of Sovereign CDS although the magazine makes no mention of them in their coverage like the way Bloomberg does. Bloomberg quoted Chris Garman of Garman Research as saying “Once you adjust Treasury yields for that [sovereign CDS price], then the current swap spread landscape looks a lot more rational……At the end of the day, sovereign default risk is a very real phenomenon and not just simply some sort of market artifact.”
Whatever the reasons investors may wish to believe for the current environment of close-to-zero if not negative swap spread may be, one indicator that markets will be need to be closely monitoring will ultimately be Sovereign CDS. Readers who wish to know the current Sovereign CDS prices of other countries besides the aforementioned USA price are invited to contact CreditLime with their requests.
Disclosure: long all stocks