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US Government Single A Rated?

Negative swap spreads cannot be a good omen for the financial markets.  Interest rate swaps are the most vanilla and widely used over-the-counter derivatives in the world.  They are an effective tool in helping institutions hedge interest rate risks.  When a company or bank issues floating rate debt but need a fixed rate profile, they can easily swap the floating rate payments to fixed payments.  When a pension or insurance company has long duration (10+ year cashflows) and they cannot find any attractive bonds, they can simply buy short cash bonds and overlay long interest rate swaps to hedge away that long interest rate exposure.  Interest Rate Swaps are critical components of the derivatives and fixed income markets.

With that as the backdrop, when something looks strange in the interest rate swap markets I tend to pay attention.  Back in July of 2009 I asked whether it made sense that 30 year interest rate swaps were trading at an interest level that was below 30 year government bonds.  In fact, 30 year swaps spreads have traded as low as -60bps (-.6% to treasuries) and have bounced around the -17bps to -4 bps level for most of 2009 and until recently.

30 Year Swap Spreads are plunging once again

I tried to explain away 30 year swap spreads being negative by suggesting that insurance companies and pension funds utilize swaps most aggressively to hedge their long-dated interest rate exposures because they do not require an outlay of cash and because they closely match the way liabilities are modeled (using the swap curve).  I guess you could say that I convinced myself that eventually the abnormality would go away and it was a temporary supply/demand issue in the markets.

Today cannot be explained away.  Ten year swap spreads have been positive throughout the crisis and remained so until yesterday.  Right now, 10 year swap spreads have plummeted to an all-time low of -8.63bps.

10 Year Interest Rate Swap Spreads to Treasuries hit ALL TIME low

The 10 year part of the interest rate curve is very liquid.  Supply/demand issues cannot be the cause of this dislocation.  So what does this all really mean?

Interest rate swaps are priced off of the LIBOR (London Inter-Bank Offering Rate) curve which is just a fancy way of saying that this curve represents the level of interest rates that banks and financial institutions of AA ratings quality are willing to lend to each other at.  If this is the case, the simple fact that US treasuries are trading at interest rate levels that are higher than swap rates would suggest that the US Government has a credit quality that is lower than the AA rated financial institutions.  In fact, it could be argued that the entire universe of financial institutions has moved lower in credit quality and may trade closer on aggregate to A+/AA- which would suggest an even lower credit rating for the government.

I will not make a statement that the US Government is a single A rated entity, but it seems that the alarm bells should be ringing.   I hope that this is not a concern over the financial solvency of the government and more of a technical anomaly driven by a glut of treasury supply.

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Posted in Derivatives, Economics, Markets, Politics, Technical Analysis.

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13 Responses

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  1. Travis Robinson says

    So Portugal no biggie?

  2. Randy Woods says

    It seems that the possibility of a US government default is assigned too high of a probability. How does one (institution or individual) profit from this? Sell US Treasury CDS? Can you short corporate paper that is trading too rich against similar US Treasuries?

  3. SurlyTrader says

    The “PIGS” will get back in the spotlight, but this recent development with swap spreads rattles me a bit. The investment banks are writing it off as “less MBS hedging due to decreased convexity” or because MBS issuance is down significantly versus treasury issuance. I don’t buy it. You can always replicate a bond with a swap and cash invested short term. That means that if you believed that the credit worthiness of the states was higher than banks, you would arb that spread away regardless of technicals.

  4. SurlyTrader says

    I agree with you and in my professional life I have somewhat placed this trade by purchasing treasury and treasury futures over the last year versus purchasing interest rate swaps at the 20+ year part of the curve with the expectation that this spread level will eventually revert back to where it fundamentally makes more sense.

    For institutions you would trade this by going long 10 year treasuries while shorting 10 year interest rate swaps (pay a lower rate than you receive).
    For individuals the trade is trickier. You would need to find a corporate ETF and short it while hedging the duration of the corporate ETF position to zero by going long treasury bonds.
    The cleaner way would be to find individual corporate bonds that are trading tighter than treasuries and make the same trade (like the buffett news article I posted a few days ago with Berkshire trading inside treasuries).

  5. spragus says

    maybe LIBOR is artificially too low?

  6. Randy Woods says

    For institutions you would trade this by going long 10 year treasuries while shorting 10 year interest rate swaps (pay a lower rate than you receive).
    Yes, that sounds like a very low risk, easy way to make money. Seems like they should be putting on as much of this as they can. Why would an insurance company or pension fund (swap customer) want to lock in a 10 year rate that is lower than a 10 year US Treasury?

  7. SurlyTrader says

    That is exactly the point. Would you rather earn 4.73% on a 30 year treasury or 4.48% on a 30 year swap issued to you by Bank of America/Merrill? I don’t care how much the government has on its balance sheet.

  8. SurlyTrader says

    That could be true, but why wouldn’t investors short swaps and go long treasuries if that was the case? It does not matter whether treasuries are too high or swaps are too low, the gap should be closed unless there is a fundamental reason for it which could only be that banks are considered more credit worthy than the Treasury.

  9. Travis Robinson says

    Still thinking the 30 year T’s are range-bound? Is this “anamoly” in the swap market (or de facto downgrade if you’d prefer) part of what’s causing the rally in rates?

  10. SurlyTrader says

    No, I actually think that this spike up in rates might be the start of a sustained movement upward in interest rates. What is strange is that equity markets seem to continue their march higher despite this backdrop…

  11. dhm says

    You say “Supply/demand issues cannot be the cause of this dislocation. ” and further on you say”…..technical anomaly driven by a glut of treasury supply…”. That seems to leave only the financial solvency option. No?

  12. SurlyTrader says

    Yes and no. I probably should have said it could not be caused by a supply/demand issue over the long-term. It is possible that in a certain week or maybe even month the 10 year swap spread goes negative over specific types of trades being made (unwinding narrowing swap spread positions alongside massive treasury issuance and a lack of MBS issuance). It could also be that this rate action has been a forecast of treasury interest rates in general and that treasuries have moved faster in anticipation of rate rises. I do not believe that the US Government has a “solvency” problem. Japan should have a solvency problem long before the United States or United Kingdom, so we might benefit by watching how things unravel over there first.

  13. EC says

    Interesting, especially about the entire universe moving lower in credit quality, reminded me of Bill Gross’ March Investment Outlook, where he said, ” If core sovereigns such as the U.S., Germany, U.K., and Japan “absorb” more and more credit risk, then the credit spreads and yields of these sovereigns should look more and more like the markets that they guarantee.”



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