Should investors care about negative swap spreads?

The relationship between government bond yields and swap rates – otherwise known as the swap spread – has been increasingly in focus, with the market’s attention turning to Europe last week as the 10-year German Bund yield traded higher than the 10-year euro swap rate for the first time ever.

In the US and the UK, government bond yields have actually been trading higher than their respective swap rates for some time, though we are now at record differentials across some maturities.

What exactly does this tightening in swap spreads tell us? And why as fixed income investors should we care about them?

What are swap spreads?

An interest rate swap enables one party to “swap” rates with another party for a specific period, typically a floating rate for a fixed rate or vice versa. A basic example would be a company with a lot of floating rate debt concerned about interest rates increasing; it would enter into a swap agreement with a financial institution to convert that floating rate into a fixed rate for a set period.

The fixed leg of the swap represents the average return expected from comparable, short-dated instruments over the given period. Put another way, an investor should be indifferent as to whether they receive the 10-year fixed swap rate or a series of floating rate payments over the same time frame.

The swap spread is the difference between the nominal yield on government bonds and that of the underlying fixed leg in a swap agreement of the same maturity.

For example, with 10-year US Treasury yields at 4.42% at the time of writing and a 10-year fixed rate US dollar swap at 3.92%, the US swap spread is -50bp. In euros, meanwhile, expectations of deeper rate cuts have reduced the 10-year swap rate by 14bp year-to-date, while at the same time 10-year Bund yields have increased by 36bp from 2.02% to 2.38%.

The swap spread essentially captures all the other factors that determine valuations in government bonds outside the market’s interest rate expectations. These factors mostly include anticipated supply and demand levels for the government bonds in question, as well as credit risk (the chance of the issuing government defaulting) and the cost of arbitraging the difference between these two similar instruments.

Why have swap spreads turned negative?

Historically, swap spreads have been positive with swap rates being higher than nominal government bond yields.

From the sovereign perspective, the recent tightening in swap spreads suggests investor concern around increased supply of government bonds, with the obvious implication of increased debt servicing costs (offsetting some of the benefit of recent rate cuts).

Recent political developments have been widely mooted as a potential factor; the UK Budget, the US election and new snap elections called in Germany all arguably point to higher government bond supply in the months and years to come, and have also brought fiscal deficits coming under increasing scrutiny.

We think a longer-term driver of the trend over the last couple years has been the effective increase in government bond supply driven by the shifting of bonds into private hands as a result of quantitative tightening. Regulation has also played some part, with various rules introduced post-2008 making the arbitrage of swap spreads more difficult for financial institutions. For reasons we don’t need to go into here, the move away from Libor in favour of the Secured Overnight Financing Rate (SOFR) could also have played a role.

What are the implications?

From a relative value and portfolio allocation perspective, the implications are less clear.

On the one hand, the more negative the swap spread, the more attractive government bonds become as a hedging instrument for credit, as they look cheap to the swap rate. In particular, demand for government bonds could increase rather quickly if recession fears were to re-emerge – always a possibility in a late-cycle environment – which would likely create strong technical support for government bonds and lead to a material widening of swap spreads. In such a scenario, government bond returns could be further compounded by the likely need for central banks to cut interest rates more rapidly.

On the other hand, the existing macroeconomic and technical picture – a benign growth outlook with fiscal deficits growing at a time of quantitative tightening – mean a further tightening of swap spreads cannot be ruled out.

The implications for market participants will vary. Government bonds have cheapened compared to swap rates, which could have consequences for those who hedge interest rate exposures through different instruments. For credit, it is worth noting that long-only asset managers tend to look at all-in yields and the spread of a given corporate bond to the benchmark government bond of the same maturity (therefore capturing the tightening in swap spreads in all-in yields). Some bond issuers, especially in the euro market, look at the spread over the swap rate since they intend to hedge the interest rate risk via a swap.

A primary issue in euros priced at 100bp over swaps in early October would have resulted in an all-in yield of 3.35%, a spread of 120bp over Bunds. An identical bond priced today at 100bp over swaps would have a spread over Bunds of only 100bp. Different market participants will focus on spreads over different rates. For us, European credit spreads look somewhat tighter as a result of the recent moves in swap spreads.