Understanding the drivers behind negative swap spreads
Issuers and investors have had to get used to an environment of heavily negative swap spreads in the US market during the last six months. Swap spreads have come back from the tightest levels seen before Christmas, however intraday volatility and big swings in the shape of the swap spread curve continue to provide a challenging backdrop for SSA issuers and investors to navigate
Swap spreads have been the major topic of conversation in the world of SSA new issues following their historic tightening both in terms of levels and volatility. And while we have moved away from the worst of the negative levels seen at the end of 2015 it appears that negative swap spreads — especially five years and longer — are here to stay.
We believe that a combination of two distinct drivers has been behind the moves:
- Structural: regulation has increased the cost of balance sheet and cheapened cash products relative to their derivative counterparts. Tighter regulation, higher capital requirements and reduced bank balance sheet capacity is the order of the day.
- Temporary: driven by trends in reserve manager flows, corporate issuance or hedging needs of insurance companies.
We believe that spreads will remain in a tighter range than historical levels would suggest, owing to structural factors. Within this tighter range, however, spreads can fluctuate based on issuance and/or hedging needs.
There has been a realisation of the rising cost of balance sheet over the past year as dealers and banks have begun to adjust to a post-leverage ratio world. This has decreased the correlation between on-balance sheet assets such as Treasuries and off-balance sheet assets such as swaps. This helps explain why Treasuries saw roughly the same degree of cheapening against OIS similar to the post-Lehman environment, when balance sheet was also dear.
We believe that these market movements can be explained by a rising cost of balance sheet due to the Supplementary Leverage Ratio (SLR) and upcoming Net Stable Funding Ratio rules (finalised rules due in 2016). The repo market is most inexorably linked to the cost of balance sheet and therefore faces the brunt of new regulations. Repo balances have shrunk by 20% since Q2 2013, when SLR was announced. Note that the SLR rules are binding for most US and European banks and disproportionality hit repo and Treasuries, which previously benefited from zero risk weighting.
Central bank reserves have been declining steadily over the past year, with the pace of decline accelerating sharply in the autumn of 2015 as the market began adjusting to upcoming rate hikes and a stronger dollar. This resulted in a significant amount of Treasury selling by foreign central banks, as evidenced by the spike in primary dealer inventories. Dealers’ inability to shed Treasuries from their balance sheets amid strong selling flows by foreign central banks resulted in cheapening of Treasuries against other assets, including swaps.
A spike in corporate bond and SSA issuance is often accompanied by increased receiving of fixed rates as issuers swap fixed rate debt to floating. January, March and September typically represent large issuance months, and are often accompanied by a tightening in spreads. A large volume of issuance in January helped drive spreads sharply tighter in early January, but the subsequent slowdown in issuance amid a spike in market volatility helped push spreads wider.
Another factor that has driven spreads tighter and the spread curve flatter has been variable annuity hedging, which accompanies sharp moves lower in equities (such as January-February 2016). VA liabilities extend in duration, creating large receiving needs when risk assets decline sharply.
Implications for SSA issuers and investors
In recent weeks we have seen a sharp widening in swap spreads in the short end of the curve due to the widening in the Libor-OIS relationship, whilst swap spreads in the long end have remained unchanged. As things stand two year swap spreads are at +14bps and 10 year swap spreads are at -13bps. This has the result of flattening the credit curve on a spread to USTs. For example KfW’s recent two year deal was priced at CT2 +26.75bps and IFC’s recent 10 year deal was priced at CT10+29.5bps. The respective mid-swaps levels for these two deals were MS +14bps for KFW and MS +44bps for IFC.
What this means for investors is that they are being forced to change their opinions on where value resides on a spread to USTs and that credit curves will remain very flat.
In the near-term, we believe that spreads may stay near the wider end of the recent range particularly in the short end, aided by the rebound in equities and a likely slower pace of corporate issuance. We look for five years to hover between 0bp and –5bp and for 10 year spreads to remain in range between –10bp and –15bp in the coming months, with some tightening likely to be seen into supply-heavy September.