Swap Spread

What Is a Swap Spread?

A swap spread is the difference between the fixed component of a given swap and the yield on a sovereign debt security with a comparative maturity. In the U.S, the latter would be a U.S. Treasury security. Swaps themselves are derivative contracts to exchange fixed interest payments for floating rate payments.

Since a Treasury bond (T-bond) is often utilized as a benchmark and its rate is viewed as default risk-free, the swap spread on a given contract is determined by the perceived risk of the parties participating in the swap. As perceived risk increments, so does the swap spread. In this manner, swap spreads can be utilized to survey the creditworthiness of participating parties.

How a Swap Spread Works

Swaps are contracts that permit individuals to deal with their risk in which two parties consent to exchange cash flows between a fixed and a floating rate holding. Generally talking, the party that gets the fixed rate flows on the swap builds their risk that rates will rise.

Simultaneously, on the off chance that rates fall, there is the risk that the original owner of the fixed rate flows will renege on a guarantee to pay that fixed rate. To compensate for these risks, 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 of breaking that guarantee to pay, the higher the swap spread.

Swap spreads correlate closely with credit spreads as they reflect the perceived risk that swap counterparties will fail to make their payments. Swap spreads are utilized by large corporations and governments to fund their operations. Typically, private entities pay more or have positive swap spreads as compared to the US government.

Swap Spreads as an Economic Indicator

In the aggregate, supply and demand factors take over. Swap spreads are essentially an indicator of the longing to hedge risk, the cost of that hedge, and the overall liquidity of the market.

The more individuals who want to swap out of their risk exposures, the more they must pay to instigate others to accept that risk. Therefore, larger swap spreads means there is a higher general level of risk aversion in the marketplace. It is likewise a check of systemic risk.

At the point when there is a swell of want to reduce risk, spreads broaden exorbitantly. It is likewise a sign that liquidity is greatly reduced similar to the case during the financial crisis of 2008.

Negative Swap Spreads

The swap spreads on 30-year swap T-bonds turned negative in 2008 and have stayed in negative territory since. The spread on 10-year T-bonds likewise fell into negative territory in late 2015 after the Chinese government sold US treasuries to release restrictions on reserve ratios for its domestic banks.

The negative rates imply that markets view government bonds as risky assets due to the bailouts of private banks and the T-bond selloffs that happened in the aftermath of 2008. But that thinking doesn't make sense of the enduring popularity of other T-bonds of shorter [duration](/duration, for example, the two-year T-bonds.

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 enlarge swap spreads has increased significantly since the financial crisis due to regulations. The return on equity (ROE) has consequently diminished. The result is a decline in the number of participants ready to enter such transactions.

Illustration of a Swap Spread

Assuming a 10-year swap has a fixed rate of 4% and a 10-year Treasury note (T-note) with a similar maturity date has a fixed rate of 3%, the swap spread would be 1% or 100 basis points: 4% - 3% = 1%.

Highlights

• Swap spreads are likewise utilized as economic indicators. Higher swap spreads are indicative of greater risk aversion in the marketplace.
• A swap spread is the difference between the fixed component of a swap and the yield on a sovereign debt security with a similar maturity.
• Liquidity was greatly reduced and 30-year swap spreads turned negative during the financial crisis of 2008.