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Discussion of the Negative (-) 10 Year Swap Spread at 27 March 2010
and Discussion of Negative Swap Spreads in general and their investment implications
Arthur O’Keefe www.spvalue.com 27 March 2010
Sao Paulo Value: Global Investment Ideas from Brazil by Arthur O'Keefe
-10Y Swap Spread: Unintended Consequence of Steep Yield Curve?
The above graph is my structural analysis of the swap market in an attempt to understand what is driving swap spreads increasingly lower such that they are now negative at the 10 year point (they have been negative at the 30 year point for a while now). Said another way, the above is my analysis of fixed and floating rate payers and receivers in the cash and derivatives markets which I will explain below.
First a look at 10 year swap spreads (now negative) in the following graph:
The recent decline below 0 (now - 9bps as can be seen at the far right of the graph) is getting a lot of press recently. For instance here is a Bloomberg article which blames the phenomenon on corporate hedging. Later Bloomberg changed its story to say that the negative swap spreads were due to a glut in Treasury securities, and this seems to have caught on a wider following.
Personally my first reaction was that there must be some structural stress going on with the market, but that does not necessarily mean that the stress is due to a view of government credit quality relative to corporate credit quality. The graph at the left, though, shows swap spreads around the world, and one can certainly see that there is a strong correlation between negative swap spreads and countries having deficit problems. Correlation, though, does not equate to causality. Also what might be causing negative swap spreads in one market does
not necessarily cause them in another.
To really dig to the bottom of this, I looked at the swap system using a framework developed by one of my professor’s at Harvard Business School, Robert C. Merton (not to be confused with Robert K. Merton, his father and acclaimed sociologist whom I will discuss as well at the end of this entry). Bob (Robert C.) Merton is best known for winning the Nobel Prize in Economics for his insight of using Ito calculus to price options (ie developing the continuos time implementation of the Black-Scholes option pricing formula) and later for participating in the rise and fall of Long Term Capital Management. So since Merton already has a Nobel and a bit of fame/notoriety, his more recent work on things like pensions (with Zvi Bodie) and structures of financial systems has not garnered much attention. In some ways, though, his more recent work is even more impactful, in my opinion, than the closed form options pricing equation (Black-Scholes) which is widely used but nevertheless confined to the universe of options and derivatives traders. In any case, Merton with Bodie (link here:) postulates that the outputs of a financial system are dependent on financial institutions and intermediaries that evolve with the politics, customs, and behaviors of a society and so apparent distortions in the financial market would therefore be partly due to a structural deficiency or friction within the institutions.
So it can be that government deficits do indeed lead to negative swap spreads, but it is not at all clear why that should be the case and how it actually happens. Where exactly is the stress of government deficits showing up and who is really bearing the risk? Is it in the banks again as zero hedge postulates? Or is it somewhere else?
Hence the graph at the top of this post dissecting the sources of fixed and floating rate exposures in the market. Along the lines of Merton’s framework, the bank is seen as an intermediary in the whole process and acts only to transmit risk between entities, though it does introduce a friction in the form of a spread that it charges for its risk transmission service. So let’s translate this intricate graph:
Corporation Block and Corporation - Bank Relationship:Starting at the bank/corporate relationship (since that was where Bloomberg originally postulated the problem started and where the stress was most evident) we see that corporations issue bonds (mostly) to hedge funds and insurers paying a fixed rate - assume for 10 years to keep with the analysis of swap spreads. Bloomberg argued that corporations then enter into a swap arrangement with Banks to receive fixed and pay floating rates for the term of the bond issuance (10 years in this case).
Before analyzing how or why a Bank would do this, let’s think like a corporate treasurer/CFO in today’s interest rate environment. Specifically let’s think like the CFO of a generic BBB corporation today. The iBoxx Domestic Corporate BBB Spread to Libor index shown to the left shows a BBB credit spread of 1.92%. This is the credit spread to swap rates that a corporation of BBB credit quality pays and is generally in line with what one sees in the market today. 10 year swap rates (also shown on the left) shows that banks borrow for 10 years at 3.71% (the 10 year Libor or Swap rate) so the cost of borrowing to the treasurer is 1.92%+3.71% = 5.63%.
So if the CFO issues a bond and does nothing else, he has locked up 10 year financing at 5.63%. But is there anything else the CFO can do to lower borrowing costs today that might also strategically fit in with the companies revenue forecasts? Yes, the CFO can swap from fixed to floating by agreeing to pay 3 month Libor resetting every 3 months for the next 10 years and in return receive the 10 year Swap rate. 3 month libor is today .28% annualized (as can be seen in the chart at the left), so if the CFO does this, borrowing costs then become 5.63% - 3.71% + .28% = 2.2%. This is a 60% reduction in costs. And what risk is being taken for this reduction? Mainly the risk that short term rates increase. But under what circumstances will short term rates increase? Probably only a recovery, and in a recovery revenues will rise before and faster than interest rates (given the large amount of excess capacity in the system, the recovery will be well underway before rates rise), so from a business perspective, this is manageable. In the meantime if the recovery is
delayed, the company continues to pay 60% less in interest than it would under a 10 year fixed arrangement. So really, the decision is a “no brainer” for the CFO. Swap to floating.
Notice in this entire analysis, the CFO does not care where 10 year government rates are trading. Actually as can be seen in the chart on the left, investing in a 10 year government bonds will pay 3.83%, whereas the bank will only pay 3.71% as noted above, so the CFO will receive 10bps less than investing in government bonds, but the CFO still does the deal because the CFO is not looking to invest money - rather merely switch from a fixed rate to floating. Said
another way, the CFO is not concerned that the fixed rate the company will receive is less that the rate that the company would receive if the company because the CFO is not looking to deploy cash but is rather looking at 2 borrowing options, and in this case the CFO is making the more rational decision and swaps. The CFO’s actions will then push the swap market lower, but nevertheless the swap market will remain attractive for the next CFO who will do the same trade. So absent some other relationship (probably an arbitrage relationship as discussed below) with other actors the swap spread will continue lower until it reaches the point of indifference between swapping from fixed to floating for the marginal corporate borrower. But, there are other relationships as we continue around the diagram at the top of the page.
Government Debt (including mortgages) Block and Government Debt - Bank Relationship:So continuing right in the graph at the top (using Merton’s framework of analyzing a bank as an intermediary as opposed to a risk taking entity) we look at the Bank’s actions in the government debt market and how these might affect swap rates. There are two items which are critical. First is that the government debt market provides a source of fixed rate exposure and second is that there is spread differential (normally positive but now negative) between swap rates and the rate in the government debt market. Thus, in theory there is a arbitrage relationship between swaps and rates that prevents swap spreads from getting too negative (with the negative value representing frictions in the banking sector). That relationship is that at a certain point it becomes very profitable for a bank to buy government debt, receive fixed, pay fixed at a higher spread, receive floating, and pay floating to receive cash to buy government debt. So linking back to the CFO above, the CFO does not need to take a view on rates but rather can rely on this arbitrage relationship to ensure that the swap rate the company receiving is not too low. There are, however, limits of arbitrage. Here the limit is the amount of leverage that a bank can employ to buy government securities (a cash obligation) to pay fixed and receive floating in a swap transaction (a cashless transaction) relative to other investment opportunities to provide a return on the same amount of equity posted to borrow to buy the government bonds. As shown above to get a 15% return on equity with a -9bps swap spread would require leverage of 15/.09 = 167x. For a 5% ROE the leverage required would be 55x. Even at the very low range of acceptable return on equity we see that the amount of leverage required is a bit extraordinary (in today’s environment), therefore it is probably safe to say that swap spreads have not yet hit a lower bound to where arbitrageurs/banks can act between bonds and the swap market to stabilize spreads. Luckily there are other relationships.
A brief note about mortgages backed by Fannie and Freddie (the vast majority in today’s environment) is that to the extent that the government or Federal reserve takes actions to “keep mortgage rates low”, ie at a low spread to government rates, these will behave like government securities in the arbitrage relationship outlined and will fail to influence swap spreads until spreads widen to a meaningful point to leverage mortgage securities to receive fixed from the mortgage market (after adjusting for all prepayment options) and pay fixed in the swap market. So an unintended consequence (see below for discussion on the general topic) of the Federal Reserve capping mortgage rates (as can be seen in the above graph from the St. Louis Fed Monetary Trends publication) is that it lowers the floor on swap spreads.
Bank Borrowers (Debtors) and Debtor - Bank Relationship:The graphs at the left taken from the St. Louis Federal Reserve Monetary Trends monthly publication give some insight into a potential cause of negative swap spreads: the decline of fixed rate borrowers. More so than from the government debt and mortgage markets, Banks source a material amount of fixed rate exposure from corporate, small business, and consumer loans. Given the recession and previous bubble in borrowings (evident left), borrowers are repaying loans and de-levering rapidly even as Banks (given swap spreads and signs of an improving economy) are getting more eager to lend as can be seen left with loosening lending standards. So we have a real sign that a critical supply of fixed payers is drying up. Normally a bank will lend at fixed + a credit spread (and recently given the crisis that credit spread has been very high) and then swap out to floating in the swaps market to receive floating which they then pay
to depositors to receive money to lend. With the decline of borrowers, it’s possible that banks are having to lend to the government in the bond market at a less attractive rate pressuring swap spreads as the banks try to maintain a profit margin.
A quick note on personal and state balance sheet repair through federal deficits which I have previously commented on. If this analysis holds, an unintended consequence of transferring private debts to the federal balance sheet is lowering (or negative) swap spreads. This is not necessarily a view on government credit quality as much as it is a result of reducing profitability of a key market intermediary- the Bank.
Bank Lenders (Bank Bond Buyers) and Lender - Bank Relationship:Banks have a outlet to pay fixed if they find themselves get long receiving fixed rates. They can issue bonds to the market which pay fixed rates. Given the obvious stress in the swap spreads market as banks get asked to pay more and more fixed rates and receive floating, it seems that banks are actually short fixed rates and so are more interested in other forms of raising cash (namely equity or deposits).
Equity Holders (Stock Holders) and Equity - Bank Relationship:Banks can raise permanent capital in the equity market (without the obligation to pay fixed rates per se) but are held accountable on their return on equity. This relationship serves to enforce on the bank that it only makes economic decisions. This contributes to the negative swap rate by imposing a limit of arbitrage in the government debt - swap rate interaction outlined above.
Depositor (included Fed) and Depositor - Bank Relationship:Just as banks can shed fixed rate exposure by issuing bonds, they can shed floating rate exposure by attracting deposits.
It is here (looking at depositor actions) that we see more signs of distortions (again from the St. Louis Fed). As noted above, in the corporate swap market we have signs that Banks are increasingly making fixed payments (and receiving floating payments) and are having trouble raising loans to source these fixed payments and are also increasingly looking for leverage in the government bond market given swap spreads but face a limit of arbitrage on leverage.
Another unintended consequence of the steep yield curve (the first being CFO’s swapping to floating) is that money is flowing out of short term (floating rate) deposits because deposits just don’t pay well in the eyes of the depositor. We see some indication of this with Libor very recently ticking up slightly (as can be seen in the graph on the left).
But it is important to remember that it is the Fed that has the largest impact on short term rates (independent of the supply of depositors to the extent that the Fed replaces depositors through open market operations) and so the effect of an unreasonably low deposit rate (that drives depositors away to other higher yielding securities or longer durations and forces the federal reserve to take open market measures to maintain low rates) manifests itself as a steep yield curve (seen left) that makes it very attractive for CFO’s to swap from fixed to floating as discussed above.
Pensions (old age insurance) and other Insurers and Insurance - Bank Relationship:The enactment of the Pension Protection Act of 2006 had the effect of requiring companies to gradually bring their retirement plans to fully funded status and maintain them that way and consequently gives strong encouragement to immunize their pension liabilities by receiving fixed rates which correspond to fixed future pension obligations. Perhaps a more tenuous link (and one which I admittedly have little evidence to support save the life expectancy chart to the left from the CDC) is that increasing life spans create longer
term liabilities in the health insurance and other markets (including an additional effect on pension liabilities). Presumably the pension issue is the dominant factor in this sector and creates a natural bid to receive fixed rates as pensions look for methods to increase portfolio duration to match liabilities.
Hedge Funds and the Hedge Fund - Bank Relationship:Lastly in the chart at the top is the hedge fund - bank relationship. Hedge funds that buy investment grade corporate debt from companies generally finance the purchases through the banking sector. They have the option to hedge interest rate exposure by swapping in one form or another to floating. Given the combination of credit spreads (at roughly 200bps) and short term interest rates (at 25bps) for a hedge fund to achieve an adequate return on equity (assumed to be 12%) without taking any interest rate risk would require leverage of 6 times (200bps * 6 = 12%). This is probably not acceptable for risk management reasons. If however funds take interest rate exposure, buy buying longer dated bonds and financing the purchase in the short term market, it is possible to achieve such a return with less than 3 times leverage. As a result it is likely that hedge funds investing in investment grade debt are electing to not hedge or to under-hedge interest rate exposure again leading to an imbalance of fixed rate receivers in the market (and an imbalance of paying fixed rates in the banking sector).
Insights, Consequences, Conclusions, Considerations and Trade Ideas:Reviewing the above discussion, I first note that credit quality of the US has not come into consideration. It can be that there are speculative positions being taken that are increasing the distortion in the swap spread market, but in my opinion this is unlikely. A key difference between the US and the so-called PIIGS - Portugal, Ireland, Italy, Greece, and Spain - is that the PIIGS cannot print their own currency of indebtedness due to the European Monetary Union. I have not explained how that can lead to negative swap rates but suffice it to say that the inability to print money in ones currency of indebtedness leads to credit risk which interferes with the government debt swap rate arbitrage relationship discussed above. The US does not have this problem and so I do not think that it is credit fears that are pushing swap spreads negative. Instead I would would guess:* Corporate hedging is likely very strong in the direction of receiving fixed due to the large
cost savings with the steep yield curve and the likely alignment with general corporate strategy to make costs variable with the recovery (spend more if the economy recovers).
* Government Bond Interest Rates are not yet high enough or the 10 Year Swap spread is not yet negative enough for the arbitrage relationship to work between these markets.
* An unintended consequence of the steep yield curve and the drive to keep mortgage rates lows is negative swap spreads.
* A reduction of general borrowings is removing an important supply of fixed rate payers which in turn leads to lower swap rates and negative swap spreads.
* An unintended consequence of taking private debts onto the public balance sheet (ie manufacturing savings) is negative swap spreads.
* Banks are at or below their lower range of desired profitability. Cost structures may be higher than historically.
* Banks are constrained by leverage and having difficulty raising deposits.* Pension funds are increasing the duration of their portfolios, competing to receive fixed.* Hedge funds are not hedging their interest rate exposure.This leads to a few themes:* The market is increasingly getting long fixed rates- that is the market is electing to receive
fixed driven largely by the slope of the yield curve.* The factors outlined above do not appear likely to change anytime soon, and therefore swap
rates are likely headed lower along with swap spreads.* There will be building pressure to flatten the yield curve as capital flows in search of higher
returns.Finally trade ideas:* Swap spreads are still not an attractive bet at this point. Risk is to even lower swap spread
especially while deflationary pressures continue.* Along these lines, due to short term deflationary pressures, receiving fixed rates is likely
going to become a crowded trade. Look for ways to take the other side....* The key to when to take a position I think is to watch loans. If lending start to pick up, swap
rates will likely rise (as will inflation). Given the crowded trade, swap rates have a potential to move sharply higher.
* An environment of rising swap rates has the potential to be positive for financial stocks as it signals a rising profitability in the business model.
* Avoid low return highly levered trades.* Long term call options on lowly levered companies could perform well as interest rates and
volatility increases. In general I like this trade even today with volatility declining as losses due to volatility drops are generally more than made up with rising equity prices.
A Brief Additional Note on Unintended Consequences and Functional Analysis:Occasionally in Bob Merton’s class at Harvard Business School I would catch hints of reference to his father, Robert King Merton, a brilliant sociologist who coined phases like self-fulfilling prophecy (which his son would reference in discussions of the rationality of bank runs) and unintended consequences. Robert K. Merton was a functionalist and presumably looked at the result of a particular structure to understand what function it was providing and thus understand its structure in a system. Thus the result was the input and the structure was the output - a demand driven analysis, which is not always the most intuitive starting point. Robert C. Merton, his son, later went to apply this same framework to understanding the financial system. Essentially bank are the way they are because that’s the structure needed in a particular society required to fulfill the needs that banks fulfill.
Arthur O’Keefe
Saturday, March 27, 2010 Go to home Go to archive
São Paulo Value: Making Sense of Negative Swap Spreads
The above graph is my structural analysis of the swap market in an attempt to understand what is driving swap spreads increasingly lower such that they are now negative at the 10 year point (they have been negative at the 30 year point for a while now). Said another way, the above is my analysis of fixed and floating rate payers and receivers in the cash and derivatives markets which I will explain below.
First a look at 10 year swap spreads (now negative) in the following graph:
The recent decline below 0 (now - 9bps as can be seen at the far right of the graph) is getting a lot of press recently. For instance here is a Bloomberg article which blames the phenomenon on corporate hedging. Later Bloomberg changed its story to say that the negative swap spreads were due to a glut in Treasury securities, and this seems to have caught on a wider following.
Personally my first reaction was that there must be some structural stress going on with the market, but that does not necessarily mean that the stress is due to a view of government credit quality relative to corporate credit quality. The graph at the left, though, shows swap spreads around the world, and one can certainly see that there is a strong correlation between negative swap spreads and countries having deficit problems. Correlation, though, does not equate to causality. Also what might be causing negative swap spreads in one market does
not necessarily cause them in another.
To really dig to the bottom of this, I looked at the swap system using a framework developed by one of my professor’s at Harvard Business School, Robert C. Merton (not to be confused with Robert K. Merton, his father and acclaimed sociologist whom I will discuss as well at the end of this entry). Bob (Robert C.) Merton is best known for winning the Nobel Prize in Economics for his insight of using Ito calculus to price options (ie developing the continuos time implementation of the Black-Scholes option pricing formula) and later for participating in the rise and fall of Long Term Capital Management. So since Merton already has a Nobel and a bit of fame/notoriety, his more recent work on things like pensions (with Zvi Bodie) and structures of financial systems has not garnered much attention. In some ways, though, his more recent work is even more impactful, in my opinion, than the closed form options pricing equation (Black-Scholes) which is widely used but nevertheless confined to the universe of options and derivatives traders. In any case, Merton with Bodie (link here:) postulates that the outputs of a financial system are dependent on financial institutions and intermediaries that evolve with the politics, customs, and behaviors of a society and so apparent distortions in the financial market would therefore be partly due to a structural deficiency or friction within the institutions.
So it can be that government deficits do indeed lead to negative swap spreads, but it is not at all clear why that should be the case and how it actually happens. Where exactly is the stress of government deficits showing up and who is really bearing the risk? Is it in the banks again as zero hedge postulates? Or is it somewhere else?
Hence the graph at the top of this post dissecting the sources of fixed and floating rate exposures in the market. Along the lines of Merton’s framework, the bank is seen as an intermediary in the whole process and acts only to transmit risk between entities, though it does introduce a friction in the form of a spread that it charges for its risk transmission service. So let’s translate this intricate graph:
Corporation Block and Corporation - Bank Relationship:Starting at the bank/corporate relationship (since that was where Bloomberg originally postulated the problem started and where the stress was most evident) we see that corporations issue bonds (mostly) to hedge funds and insurers paying a fixed rate - assume for 10 years to keep with the analysis of swap spreads. Bloomberg argued that corporations then enter into a swap arrangement with Banks to receive fixed and pay floating rates for the term of the bond issuance (10 years in this case).
Before analyzing how or why a Bank would do this, let’s think like a corporate treasurer/CFO in today’s interest rate environment. Specifically let’s think like the CFO of a generic BBB corporation today. The iBoxx Domestic Corporate BBB Spread to Libor index shown to the left shows a BBB credit spread of 1.92%. This is the credit spread to swap rates that a corporation of BBB credit quality pays and is generally in line with what one sees in the market today. 10 year swap rates (also shown on the left) shows that banks borrow for 10 years at 3.71% (the 10 year Libor or Swap rate) so the cost of borrowing to the treasurer is 1.92%+3.71% = 5.63%.
So if the CFO issues a bond and does nothing else, he has locked up 10 year financing at 5.63%. But is there anything else the CFO can do to lower borrowing costs today that might also strategically fit in with the companies revenue forecasts? Yes, the CFO can swap from fixed to floating by agreeing to pay 3 month Libor resetting every 3 months for the next 10 years and in return receive the 10 year Swap rate. 3 month libor is today .28% annualized (as can be seen in the chart at the left), so if the CFO does this, borrowing costs then become 5.63% - 3.71% + .28% = 2.2%. This is a 60% reduction in costs. And what risk is being taken for this reduction? Mainly the risk that short term rates increase. But under what circumstances will short term rates increase? Probably only a recovery, and in a recovery revenues will rise before and faster than interest rates (given the large amount of excess capacity in the system, the recovery will be well underway before rates rise), so from a business perspective, this is manageable. In the meantime if the recovery is
delayed, the company continues to pay 60% less in interest than it would under a 10 year fixed arrangement. So really, the decision is a “no brainer” for the CFO. Swap to floating.
Notice in this entire analysis, the CFO does not care where 10 year government rates are trading. Actually as can be seen in the chart on the left, investing in a 10 year government bonds will pay 3.83%, whereas the bank will only pay 3.71% as noted above, so the CFO will receive 10bps less than investing in government bonds, but the CFO still does the deal because the CFO is not looking to invest money - rather merely switch from a fixed rate to floating. Said
another way, the CFO is not concerned that the fixed rate the company will receive is less that the rate that the company would receive if the company because the CFO is not looking to deploy cash but is rather looking at 2 borrowing options, and in this case the CFO is making the more rational decision and swaps. The CFO’s actions will then push the swap market lower, but nevertheless the swap market will remain attractive for the next CFO who will do the same trade. So absent some other relationship (probably an arbitrage relationship as discussed below) with other actors the swap spread will continue lower until it reaches the point of indifference between swapping from fixed to floating for the marginal corporate borrower. But, there are other relationships as we continue around the diagram at the top of the page.
Government Debt (including mortgages) Block and Government Debt - Bank Relationship:So continuing right in the graph at the top (using Merton’s framework of analyzing a bank as an intermediary as opposed to a risk taking entity) we look at the Bank’s actions in the government debt market and how these might affect swap rates. There are two items which are critical. First is that the government debt market provides a source of fixed rate exposure and second is that there is spread differential (normally positive but now negative) between swap rates and the rate in the government debt market. Thus, in theory there is a arbitrage relationship between swaps and rates that prevents swap spreads from getting too negative (with the negative value representing frictions in the banking sector). That relationship is that at a certain point it becomes very profitable for a bank to buy government debt, receive fixed, pay fixed at a higher spread, receive floating, and pay floating to receive cash to buy government debt. So linking back to the CFO above, the CFO does not need to take a view on rates but rather can rely on this arbitrage relationship to ensure that the swap rate the company receiving is not too low. There are, however, limits of arbitrage. Here the limit is the amount of leverage that a bank can employ to buy government securities (a cash obligation) to pay fixed and receive floating in a swap transaction (a cashless transaction) relative to other investment opportunities to provide a return on the same amount of equity posted to borrow to buy the government bonds. As shown above to get a 15% return on equity with a -9bps swap spread would require leverage of 15/.09 = 167x. For a 5% ROE the leverage required would be 55x. Even at the very low range of acceptable return on equity we see that the amount of leverage required is a bit extraordinary (in today’s environment), therefore it is probably safe to say that swap spreads have not yet hit a lower bound to where arbitrageurs/banks can act between bonds and the swap market to stabilize spreads. Luckily there are other relationships.
A brief note about mortgages backed by Fannie and Freddie (the vast majority in today’s environment) is that to the extent that the government or Federal reserve takes actions to “keep mortgage rates low”, ie at a low spread to government rates, these will behave like government securities in the arbitrage relationship outlined and will fail to influence swap spreads until spreads widen to a meaningful point to leverage mortgage securities to receive fixed from the mortgage market (after adjusting for all prepayment options) and pay fixed in the swap market. So an unintended consequence (see below for discussion on the general topic) of the Federal Reserve capping mortgage rates (as can be seen in the above graph from the St. Louis Fed Monetary Trends publication) is that it lowers the floor on swap spreads.
Bank Borrowers (Debtors) and Debtor - Bank Relationship:The graphs at the left taken from the St. Louis Federal Reserve Monetary Trends monthly publication give some insight into a potential cause of negative swap spreads: the decline of fixed rate borrowers. More so than from the government debt and mortgage markets, Banks source a material amount of fixed rate exposure from corporate, small business, and consumer loans. Given the recession and previous bubble in borrowings (evident left), borrowers are repaying loans and de-levering rapidly even as Banks (given swap spreads and signs of an improving economy) are getting more eager to lend as can be seen left with loosening lending standards. So we have a real sign that a critical supply of fixed payers is drying up. Normally a bank will lend at fixed + a credit spread (and recently given the crisis that credit spread has been very high) and then swap out to floating in the swaps market to receive floating which they then pay
to depositors to receive money to lend. With the decline of borrowers, it’s possible that banks are having to lend to the government in the bond market at a less attractive rate pressuring swap spreads as the banks try to maintain a profit margin.
A quick note on personal and state balance sheet repair through federal deficits which I have previously commented on. If this analysis holds, an unintended consequence of transferring private debts to the federal balance sheet is lowering (or negative) swap spreads. This is not necessarily a view on government credit quality as much as it is a result of reducing profitability of a key market intermediary- the Bank.
Bank Lenders (Bank Bond Buyers) and Lender - Bank Relationship:Banks have a outlet to pay fixed if they find themselves get long receiving fixed rates. They can issue bonds to the market which pay fixed rates. Given the obvious stress in the swap spreads market as banks get asked to pay more and more fixed rates and receive floating, it seems that banks are actually short fixed rates and so are more interested in other forms of raising cash (namely equity or deposits).
Equity Holders (Stock Holders) and Equity - Bank Relationship:Banks can raise permanent capital in the equity market (without the obligation to pay fixed rates per se) but are held accountable on their return on equity. This relationship serves to enforce on the bank that it only makes economic decisions. This contributes to the negative swap rate by imposing a limit of arbitrage in the government debt - swap rate interaction outlined above.
Depositor (included Fed) and Depositor - Bank Relationship:Just as banks can shed fixed rate exposure by issuing bonds, they can shed floating rate exposure by attracting deposits.
It is here (looking at depositor actions) that we see more signs of distortions (again from the St. Louis Fed). As noted above, in the corporate swap market we have signs that Banks are increasingly making fixed payments (and receiving floating payments) and are having trouble raising loans to source these fixed payments and are also increasingly looking for leverage in the government bond market given swap spreads but face a limit of arbitrage on leverage.
Another unintended consequence of the steep yield curve (the first being CFO’s swapping to floating) is that money is flowing out of short term (floating rate) deposits because deposits just don’t pay well in the eyes of the depositor. We see some indication of this with Libor very recently ticking up slightly (as can be seen in the graph on the left).
But it is important to remember that it is the Fed that has the largest impact on short term rates (independent of the supply of depositors to the extent that the Fed replaces depositors through open market operations) and so the effect of an unreasonably low deposit rate (that drives depositors away to other higher yielding securities or longer durations and forces the federal reserve to take open market measures to maintain low rates) manifests itself as a steep yield curve (seen left) that makes it very attractive for CFO’s to swap from fixed to floating as discussed above.
Pensions (old age insurance) and other Insurers and Insurance - Bank Relationship:The enactment of the Pension Protection Act of 2006 had the effect of requiring companies to gradually bring their retirement plans to fully funded status and maintain them that way and consequently gives strong encouragement to immunize their pension liabilities by receiving fixed rates which correspond to fixed future pension obligations. Perhaps a more tenuous link (and one which I admittedly have little evidence to support save the life expectancy chart to the left from the CDC) is that increasing life spans create longer
term liabilities in the health insurance and other markets (including an additional effect on pension liabilities). Presumably the pension issue is the dominant factor in this sector and creates a natural bid to receive fixed rates as pensions look for methods to increase portfolio duration to match liabilities.
Hedge Funds and the Hedge Fund - Bank Relationship:Lastly in the chart at the top is the hedge fund - bank relationship. Hedge funds that buy investment grade corporate debt from companies generally finance the purchases through the banking sector. They have the option to hedge interest rate exposure by swapping in one form or another to floating. Given the combination of credit spreads (at roughly 200bps) and short term interest rates (at 25bps) for a hedge fund to achieve an adequate return on equity (assumed to be 12%) without taking any interest rate risk would require leverage of 6 times (200bps * 6 = 12%). This is probably not acceptable for risk management reasons. If however funds take interest rate exposure, buy buying longer dated bonds and financing the purchase in the short term market, it is possible to achieve such a return with less than 3 times leverage. As a result it is likely that hedge funds investing in investment grade debt are electing to not hedge or to under-hedge interest rate exposure again leading to an imbalance of fixed rate receivers in the market (and an imbalance of paying fixed rates in the banking sector).
Insights, Consequences, Conclusions, Considerations and Trade Ideas:Reviewing the above discussion, I first note that credit quality of the US has not come into consideration. It can be that there are speculative positions being taken that are increasing the distortion in the swap spread market, but in my opinion this is unlikely. A key difference between the US and the so-called PIIGS - Portugal, Ireland, Italy, Greece, and Spain - is that the PIIGS cannot print their own currency of indebtedness due to the European Monetary Union. I have not explained how that can lead to negative swap rates but suffice it to say that the inability to print money in ones currency of indebtedness leads to credit risk which interferes with the government debt swap rate arbitrage relationship discussed above. The US does not have this problem and so I do not think that it is credit fears that are pushing swap spreads negative. Instead I would would guess:* Corporate hedging is likely very strong in the direction of receiving fixed due to the large
cost savings with the steep yield curve and the likely alignment with general corporate strategy to make costs variable with the recovery (spend more if the economy recovers).
* Government Bond Interest Rates are not yet high enough or the 10 Year Swap spread is not yet negative enough for the arbitrage relationship to work between these markets.
* An unintended consequence of the steep yield curve and the drive to keep mortgage rates lows is negative swap spreads.
* A reduction of general borrowings is removing an important supply of fixed rate payers which in turn leads to lower swap rates and negative swap spreads.
* An unintended consequence of taking private debts onto the public balance sheet (ie manufacturing savings) is negative swap spreads.
* Banks are at or below their lower range of desired profitability. Cost structures may be higher than historically.
* Banks are constrained by leverage and having difficulty raising deposits.* Pension funds are increasing the duration of their portfolios, competing to receive fixed.* Hedge funds are not hedging their interest rate exposure.This leads to a few themes:* The market is increasingly getting long fixed rates- that is the market is electing to receive
fixed driven largely by the slope of the yield curve.* The factors outlined above do not appear likely to change anytime soon, and therefore swap
rates are likely headed lower along with swap spreads.* There will be building pressure to flatten the yield curve as capital flows in search of higher
returns.Finally trade ideas:* Swap spreads are still not an attractive bet at this point. Risk is to even lower swap spread
especially while deflationary pressures continue.* Along these lines, due to short term deflationary pressures, receiving fixed rates is likely
going to become a crowded trade. Look for ways to take the other side....* The key to when to take a position I think is to watch loans. If lending start to pick up, swap
rates will likely rise (as will inflation). Given the crowded trade, swap rates have a potential to move sharply higher.
* An environment of rising swap rates has the potential to be positive for financial stocks as it signals a rising profitability in the business model.
* Avoid low return highly levered trades.* Long term call options on lowly levered companies could perform well as interest rates and
volatility increases. In general I like this trade even today with volatility declining as losses due to volatility drops are generally more than made up with rising equity prices.
A Brief Additional Note on Unintended Consequences and Functional Analysis:Occasionally in Bob Merton’s class at Harvard Business School I would catch hints of reference to his father, Robert King Merton, a brilliant sociologist who coined phases like self-fulfilling prophecy (which his son would reference in discussions of the rationality of bank runs) and unintended consequences. Robert K. Merton was a functionalist and presumably looked at the result of a particular structure to understand what function it was providing and thus understand its structure in a system. Thus the result was the input and the structure was the output - a demand driven analysis, which is not always the most intuitive starting point. Robert C. Merton, his son, later went to apply this same framework to understanding the financial system. Essentially bank are the way they are because that’s the structure needed in a particular society required to fulfill the needs that banks fulfill.
Arthur O’Keefe
The above graph is my structural analysis of the swap market in an attempt to understand what is driving swap spreads increasingly lower such that they are now negative at the 10 year point (they have been negative at the 30 year point for a while now). Said another way, the above is my analysis of fixed and floating rate payers and receivers in the cash and derivatives markets which I will explain below.
First a look at 10 year swap spreads (now negative) in the following graph:
The recent decline below 0 (now - 9bps as can be seen at the far right of the graph) is getting a lot of press recently. For instance here is a Bloomberg article which blames the phenomenon on corporate hedging. Later Bloomberg changed its story to say that the negative swap spreads were due to a glut in Treasury securities, and this seems to have caught on a wider following.
Personally my first reaction was that there must be some structural stress going on with the market, but that does not necessarily mean that the stress is due to a view of government credit quality relative to corporate credit quality. The graph at the left, though, shows swap spreads around the world, and one can certainly see that there is a strong correlation between negative swap spreads and countries having deficit problems. Correlation, though, does not equate to causality. Also what might be causing negative swap spreads in one market does
not necessarily cause them in another.
To really dig to the bottom of this, I looked at the swap system using a framework developed by one of my professor’s at Harvard Business School, Robert C. Merton (not to be confused with Robert K. Merton, his father and acclaimed sociologist whom I will discuss as well at the end of this entry). Bob (Robert C.) Merton is best known for winning the Nobel Prize in Economics for his insight of using Ito calculus to price options (ie developing the continuos time implementation of the Black-Scholes option pricing formula) and later for participating in the rise and fall of Long Term Capital Management. So since Merton already has a Nobel and a bit of fame/notoriety, his more recent work on things like pensions (with Zvi Bodie) and structures of financial systems has not garnered much attention. In some ways, though, his more recent work is even more impactful, in my opinion, than the closed form options pricing equation (Black-Scholes) which is widely used but nevertheless confined to the universe of options and derivatives traders. In any case, Merton with Bodie (link here:) postulates that the outputs of a financial system are dependent on financial institutions and intermediaries that evolve with the politics, customs, and behaviors of a society and so apparent distortions in the financial market would therefore be partly due to a structural deficiency or friction within the institutions.
So it can be that government deficits do indeed lead to negative swap spreads, but it is not at all clear why that should be the case and how it actually happens. Where exactly is the stress of government deficits showing up and who is really bearing the risk? Is it in the banks again as zero hedge postulates? Or is it somewhere else?
Hence the graph at the top of this post dissecting the sources of fixed and floating rate exposures in the market. Along the lines of Merton’s framework, the bank is seen as an intermediary in the whole process and acts only to transmit risk between entities, though it does introduce a friction in the form of a spread that it charges for its risk transmission service. So let’s translate this intricate graph:
Corporation Block and Corporation - Bank Relationship:Starting at the bank/corporate relationship (since that was where Bloomberg originally postulated the problem started and where the stress was most evident) we see that corporations issue bonds (mostly) to hedge funds and insurers paying a fixed rate - assume for 10 years to keep with the analysis of swap spreads. Bloomberg argued that corporations then enter into a swap arrangement with Banks to receive fixed and pay floating rates for the term of the bond issuance (10 years in this case).
Before analyzing how or why a Bank would do this, let’s think like a corporate treasurer/CFO in today’s interest rate environment. Specifically let’s think like the CFO of a generic BBB corporation today. The iBoxx Domestic Corporate BBB Spread to Libor index shown to the left shows a BBB credit spread of 1.92%. This is the credit spread to swap rates that a corporation of BBB credit quality pays and is generally in line with what one sees in the market today. 10 year swap rates (also shown on the left) shows that banks borrow for 10 years at 3.71% (the 10 year Libor or Swap rate) so the cost of borrowing to the treasurer is 1.92%+3.71% = 5.63%.
So if the CFO issues a bond and does nothing else, he has locked up 10 year financing at 5.63%. But is there anything else the CFO can do to lower borrowing costs today that might also strategically fit in with the companies revenue forecasts? Yes, the CFO can swap from fixed to floating by agreeing to pay 3 month Libor resetting every 3 months for the next 10 years and in return receive the 10 year Swap rate. 3 month libor is today .28% annualized (as can be seen in the chart at the left), so if the CFO does this, borrowing costs then become 5.63% - 3.71% + .28% = 2.2%. This is a 60% reduction in costs. And what risk is being taken for this reduction? Mainly the risk that short term rates increase. But under what circumstances will short term rates increase? Probably only a recovery, and in a recovery revenues will rise before and faster than interest rates (given the large amount of excess capacity in the system, the recovery will be well underway before rates rise), so from a business perspective, this is manageable. In the meantime if the recovery is
delayed, the company continues to pay 60% less in interest than it would under a 10 year fixed arrangement. So really, the decision is a “no brainer” for the CFO. Swap to floating.
Notice in this entire analysis, the CFO does not care where 10 year government rates are trading. Actually as can be seen in the chart on the left, investing in a 10 year government bonds will pay 3.83%, whereas the bank will only pay 3.71% as noted above, so the CFO will receive 10bps less than investing in government bonds, but the CFO still does the deal because the CFO is not looking to invest money - rather merely switch from a fixed rate to floating. Said
another way, the CFO is not concerned that the fixed rate the company will receive is less that the rate that the company would receive if the company because the CFO is not looking to deploy cash but is rather looking at 2 borrowing options, and in this case the CFO is making the more rational decision and swaps. The CFO’s actions will then push the swap market lower, but nevertheless the swap market will remain attractive for the next CFO who will do the same trade. So absent some other relationship (probably an arbitrage relationship as discussed below) with other actors the swap spread will continue lower until it reaches the point of indifference between swapping from fixed to floating for the marginal corporate borrower. But, there are other relationships as we continue around the diagram at the top of the page.
Government Debt (including mortgages) Block and Government Debt - Bank Relationship:So continuing right in the graph at the top (using Merton’s framework of analyzing a bank as an intermediary as opposed to a risk taking entity) we look at the Bank’s actions in the government debt market and how these might affect swap rates. There are two items which are critical. First is that the government debt market provides a source of fixed rate exposure and second is that there is spread differential (normally positive but now negative) between swap rates and the rate in the government debt market. Thus, in theory there is a arbitrage relationship between swaps and rates that prevents swap spreads from getting too negative (with the negative value representing frictions in the banking sector). That relationship is that at a certain point it becomes very profitable for a bank to buy government debt, receive fixed, pay fixed at a higher spread, receive floating, and pay floating to receive cash to buy government debt. So linking back to the CFO above, the CFO does not need to take a view on rates but rather can rely on this arbitrage relationship to ensure that the swap rate the company receiving is not too low. There are, however, limits of arbitrage. Here the limit is the amount of leverage that a bank can employ to buy government securities (a cash obligation) to pay fixed and receive floating in a swap transaction (a cashless transaction) relative to other investment opportunities to provide a return on the same amount of equity posted to borrow to buy the government bonds. As shown above to get a 15% return on equity with a -9bps swap spread would require leverage of 15/.09 = 167x. For a 5% ROE the leverage required would be 55x. Even at the very low range of acceptable return on equity we see that the amount of leverage required is a bit extraordinary (in today’s environment), therefore it is probably safe to say that swap spreads have not yet hit a lower bound to where arbitrageurs/banks can act between bonds and the swap market to stabilize spreads. Luckily there are other relationships.
A brief note about mortgages backed by Fannie and Freddie (the vast majority in today’s environment) is that to the extent that the government or Federal reserve takes actions to “keep mortgage rates low”, ie at a low spread to government rates, these will behave like government securities in the arbitrage relationship outlined and will fail to influence swap spreads until spreads widen to a meaningful point to leverage mortgage securities to receive fixed from the mortgage market (after adjusting for all prepayment options) and pay fixed in the swap market. So an unintended consequence (see below for discussion on the general topic) of the Federal Reserve capping mortgage rates (as can be seen in the above graph from the St. Louis Fed Monetary Trends publication) is that it lowers the floor on swap spreads.
Bank Borrowers (Debtors) and Debtor - Bank Relationship:The graphs at the left taken from the St. Louis Federal Reserve Monetary Trends monthly publication give some insight into a potential cause of negative swap spreads: the decline of fixed rate borrowers. More so than from the government debt and mortgage markets, Banks source a material amount of fixed rate exposure from corporate, small business, and consumer loans. Given the recession and previous bubble in borrowings (evident left), borrowers are repaying loans and de-levering rapidly even as Banks (given swap spreads and signs of an improving economy) are getting more eager to lend as can be seen left with loosening lending standards. So we have a real sign that a critical supply of fixed payers is drying up. Normally a bank will lend at fixed + a credit spread (and recently given the crisis that credit spread has been very high) and then swap out to floating in the swaps market to receive floating which they then pay
to depositors to receive money to lend. With the decline of borrowers, it’s possible that banks are having to lend to the government in the bond market at a less attractive rate pressuring swap spreads as the banks try to maintain a profit margin.
A quick note on personal and state balance sheet repair through federal deficits which I have previously commented on. If this analysis holds, an unintended consequence of transferring private debts to the federal balance sheet is lowering (or negative) swap spreads. This is not necessarily a view on government credit quality as much as it is a result of reducing profitability of a key market intermediary- the Bank.
Bank Lenders (Bank Bond Buyers) and Lender - Bank Relationship:Banks have a outlet to pay fixed if they find themselves get long receiving fixed rates. They can issue bonds to the market which pay fixed rates. Given the obvious stress in the swap spreads market as banks get asked to pay more and more fixed rates and receive floating, it seems that banks are actually short fixed rates and so are more interested in other forms of raising cash (namely equity or deposits).
Equity Holders (Stock Holders) and Equity - Bank Relationship:Banks can raise permanent capital in the equity market (without the obligation to pay fixed rates per se) but are held accountable on their return on equity. This relationship serves to enforce on the bank that it only makes economic decisions. This contributes to the negative swap rate by imposing a limit of arbitrage in the government debt - swap rate interaction outlined above.
Depositor (included Fed) and Depositor - Bank Relationship:Just as banks can shed fixed rate exposure by issuing bonds, they can shed floating rate exposure by attracting deposits.
It is here (looking at depositor actions) that we see more signs of distortions (again from the St. Louis Fed). As noted above, in the corporate swap market we have signs that Banks are increasingly making fixed payments (and receiving floating payments) and are having trouble raising loans to source these fixed payments and are also increasingly looking for leverage in the government bond market given swap spreads but face a limit of arbitrage on leverage.
Another unintended consequence of the steep yield curve (the first being CFO’s swapping to floating) is that money is flowing out of short term (floating rate) deposits because deposits just don’t pay well in the eyes of the depositor. We see some indication of this with Libor very recently ticking up slightly (as can be seen in the graph on the left).
But it is important to remember that it is the Fed that has the largest impact on short term rates (independent of the supply of depositors to the extent that the Fed replaces depositors through open market operations) and so the effect of an unreasonably low deposit rate (that drives depositors away to other higher yielding securities or longer durations and forces the federal reserve to take open market measures to maintain low rates) manifests itself as a steep yield curve (seen left) that makes it very attractive for CFO’s to swap from fixed to floating as discussed above.
Pensions (old age insurance) and other Insurers and Insurance - Bank Relationship:The enactment of the Pension Protection Act of 2006 had the effect of requiring companies to gradually bring their retirement plans to fully funded status and maintain them that way and consequently gives strong encouragement to immunize their pension liabilities by receiving fixed rates which correspond to fixed future pension obligations. Perhaps a more tenuous link (and one which I admittedly have little evidence to support save the life expectancy chart to the left from the CDC) is that increasing life spans create longer
term liabilities in the health insurance and other markets (including an additional effect on pension liabilities). Presumably the pension issue is the dominant factor in this sector and creates a natural bid to receive fixed rates as pensions look for methods to increase portfolio duration to match liabilities.
Hedge Funds and the Hedge Fund - Bank Relationship:Lastly in the chart at the top is the hedge fund - bank relationship. Hedge funds that buy investment grade corporate debt from companies generally finance the purchases through the banking sector. They have the option to hedge interest rate exposure by swapping in one form or another to floating. Given the combination of credit spreads (at roughly 200bps) and short term interest rates (at 25bps) for a hedge fund to achieve an adequate return on equity (assumed to be 12%) without taking any interest rate risk would require leverage of 6 times (200bps * 6 = 12%). This is probably not acceptable for risk management reasons. If however funds take interest rate exposure, buy buying longer dated bonds and financing the purchase in the short term market, it is possible to achieve such a return with less than 3 times leverage. As a result it is likely that hedge funds investing in investment grade debt are electing to not hedge or to under-hedge interest rate exposure again leading to an imbalance of fixed rate receivers in the market (and an imbalance of paying fixed rates in the banking sector).
Insights, Consequences, Conclusions, Considerations and Trade Ideas:Reviewing the above discussion, I first note that credit quality of the US has not come into consideration. It can be that there are speculative positions being taken that are increasing the distortion in the swap spread market, but in my opinion this is unlikely. A key difference between the US and the so-called PIIGS - Portugal, Ireland, Italy, Greece, and Spain - is that the PIIGS cannot print their own currency of indebtedness due to the European Monetary Union. I have not explained how that can lead to negative swap rates but suffice it to say that the inability to print money in ones currency of indebtedness leads to credit risk which interferes with the government debt swap rate arbitrage relationship discussed above. The US does not have this problem and so I do not think that it is credit fears that are pushing swap spreads negative. Instead I would would guess:* Corporate hedging is likely very strong in the direction of receiving fixed due to the large
cost savings with the steep yield curve and the likely alignment with general corporate strategy to make costs variable with the recovery (spend more if the economy recovers).
* Government Bond Interest Rates are not yet high enough or the 10 Year Swap spread is not yet negative enough for the arbitrage relationship to work between these markets.
* An unintended consequence of the steep yield curve and the drive to keep mortgage rates lows is negative swap spreads.
* A reduction of general borrowings is removing an important supply of fixed rate payers which in turn leads to lower swap rates and negative swap spreads.
* An unintended consequence of taking private debts onto the public balance sheet (ie manufacturing savings) is negative swap spreads.
* Banks are at or below their lower range of desired profitability. Cost structures may be higher than historically.
* Banks are constrained by leverage and having difficulty raising deposits.* Pension funds are increasing the duration of their portfolios, competing to receive fixed.* Hedge funds are not hedging their interest rate exposure.This leads to a few themes:* The market is increasingly getting long fixed rates- that is the market is electing to receive
fixed driven largely by the slope of the yield curve.* The factors outlined above do not appear likely to change anytime soon, and therefore swap
rates are likely headed lower along with swap spreads.* There will be building pressure to flatten the yield curve as capital flows in search of higher
returns.Finally trade ideas:* Swap spreads are still not an attractive bet at this point. Risk is to even lower swap spread
especially while deflationary pressures continue.* Along these lines, due to short term deflationary pressures, receiving fixed rates is likely
going to become a crowded trade. Look for ways to take the other side....* The key to when to take a position I think is to watch loans. If lending start to pick up, swap
rates will likely rise (as will inflation). Given the crowded trade, swap rates have a potential to move sharply higher.
* An environment of rising swap rates has the potential to be positive for financial stocks as it signals a rising profitability in the business model.
* Avoid low return highly levered trades.* Long term call options on lowly levered companies could perform well as interest rates and
volatility increases. In general I like this trade even today with volatility declining as losses due to volatility drops are generally more than made up with rising equity prices.
A Brief Additional Note on Unintended Consequences and Functional Analysis:Occasionally in Bob Merton’s class at Harvard Business School I would catch hints of reference to his father, Robert King Merton, a brilliant sociologist who coined phases like self-fulfilling prophecy (which his son would reference in discussions of the rationality of bank runs) and unintended consequences. Robert K. Merton was a functionalist and presumably looked at the result of a particular structure to understand what function it was providing and thus understand its structure in a system. Thus the result was the input and the structure was the output - a demand driven analysis, which is not always the most intuitive starting point. Robert C. Merton, his son, later went to apply this same framework to understanding the financial system. Essentially bank are the way they are because that’s the structure needed in a particular society required to fulfill the needs that banks fulfill.
Arthur O’Keefe
The above graph is my structural analysis of the swap market in an attempt to understand what is driving swap spreads increasingly lower such that they are now negative at the 10 year point (they have been negative at the 30 year point for a while now). Said another way, the above is my analysis of fixed and floating rate payers and receivers in the cash and derivatives markets which I will explain below.
First a look at 10 year swap spreads (now negative) in the following graph:
The recent decline below 0 (now - 9bps as can be seen at the far right of the graph) is getting a lot of press recently. For instance here is a Bloomberg article which blames the phenomenon on corporate hedging. Later Bloomberg changed its story to say that the negative swap spreads were due to a glut in Treasury securities, and this seems to have caught on a wider following.
Personally my first reaction was that there must be some structural stress going on with the market, but that does not necessarily mean that the stress is due to a view of government credit quality relative to corporate credit quality. The graph at the left, though, shows swap spreads around the world, and one can certainly see that there is a strong correlation between negative swap spreads and countries having deficit problems. Correlation, though, does not equate to causality. Also what might be causing negative swap spreads in one market does
not necessarily cause them in another.
To really dig to the bottom of this, I looked at the swap system using a framework developed by one of my professor’s at Harvard Business School, Robert C. Merton (not to be confused with Robert K. Merton, his father and acclaimed sociologist whom I will discuss as well at the end of this entry). Bob (Robert C.) Merton is best known for winning the Nobel Prize in Economics for his insight of using Ito calculus to price options (ie developing the continuos time implementation of the Black-Scholes option pricing formula) and later for participating in the rise and fall of Long Term Capital Management. So since Merton already has a Nobel and a bit of fame/notoriety, his more recent work on things like pensions (with Zvi Bodie) and structures of financial systems has not garnered much attention. In some ways, though, his more recent work is even more impactful, in my opinion, than the closed form options pricing equation (Black-Scholes) which is widely used but nevertheless confined to the universe of options and derivatives traders. In any case, Merton with Bodie (link here:) postulates that the outputs of a financial system are dependent on financial institutions and intermediaries that evolve with the politics, customs, and behaviors of a society and so apparent distortions in the financial market would therefore be partly due to a structural deficiency or friction within the institutions.
So it can be that government deficits do indeed lead to negative swap spreads, but it is not at all clear why that should be the case and how it actually happens. Where exactly is the stress of government deficits showing up and who is really bearing the risk? Is it in the banks again as zero hedge postulates? Or is it somewhere else?
Hence the graph at the top of this post dissecting the sources of fixed and floating rate exposures in the market. Along the lines of Merton’s framework, the bank is seen as an intermediary in the whole process and acts only to transmit risk between entities, though it does introduce a friction in the form of a spread that it charges for its risk transmission service. So let’s translate this intricate graph:
Corporation Block and Corporation - Bank Relationship:Starting at the bank/corporate relationship (since that was where Bloomberg originally postulated the problem started and where the stress was most evident) we see that corporations issue bonds (mostly) to hedge funds and insurers paying a fixed rate - assume for 10 years to keep with the analysis of swap spreads. Bloomberg argued that corporations then enter into a swap arrangement with Banks to receive fixed and pay floating rates for the term of the bond issuance (10 years in this case).
Before analyzing how or why a Bank would do this, let’s think like a corporate treasurer/CFO in today’s interest rate environment. Specifically let’s think like the CFO of a generic BBB corporation today. The iBoxx Domestic Corporate BBB Spread to Libor index shown to the left shows a BBB credit spread of 1.92%. This is the credit spread to swap rates that a corporation of BBB credit quality pays and is generally in line with what one sees in the market today. 10 year swap rates (also shown on the left) shows that banks borrow for 10 years at 3.71% (the 10 year Libor or Swap rate) so the cost of borrowing to the treasurer is 1.92%+3.71% = 5.63%.
So if the CFO issues a bond and does nothing else, he has locked up 10 year financing at 5.63%. But is there anything else the CFO can do to lower borrowing costs today that might also strategically fit in with the companies revenue forecasts? Yes, the CFO can swap from fixed to floating by agreeing to pay 3 month Libor resetting every 3 months for the next 10 years and in return receive the 10 year Swap rate. 3 month libor is today .28% annualized (as can be seen in the chart at the left), so if the CFO does this, borrowing costs then become 5.63% - 3.71% + .28% = 2.2%. This is a 60% reduction in costs. And what risk is being taken for this reduction? Mainly the risk that short term rates increase. But under what circumstances will short term rates increase? Probably only a recovery, and in a recovery revenues will rise before and faster than interest rates (given the large amount of excess capacity in the system, the recovery will be well underway before rates rise), so from a business perspective, this is manageable. In the meantime if the recovery is
delayed, the company continues to pay 60% less in interest than it would under a 10 year fixed arrangement. So really, the decision is a “no brainer” for the CFO. Swap to floating.
Notice in this entire analysis, the CFO does not care where 10 year government rates are trading. Actually as can be seen in the chart on the left, investing in a 10 year government bonds will pay 3.83%, whereas the bank will only pay 3.71% as noted above, so the CFO will receive 10bps less than investing in government bonds, but the CFO still does the deal because the CFO is not looking to invest money - rather merely switch from a fixed rate to floating. Said
another way, the CFO is not concerned that the fixed rate the company will receive is less that the rate that the company would receive if the company because the CFO is not looking to deploy cash but is rather looking at 2 borrowing options, and in this case the CFO is making the more rational decision and swaps. The CFO’s actions will then push the swap market lower, but nevertheless the swap market will remain attractive for the next CFO who will do the same trade. So absent some other relationship (probably an arbitrage relationship as discussed below) with other actors the swap spread will continue lower until it reaches the point of indifference between swapping from fixed to floating for the marginal corporate borrower. But, there are other relationships as we continue around the diagram at the top of the page.
Government Debt (including mortgages) Block and Government Debt - Bank Relationship:So continuing right in the graph at the top (using Merton’s framework of analyzing a bank as an intermediary as opposed to a risk taking entity) we look at the Bank’s actions in the government debt market and how these might affect swap rates. There are two items which are critical. First is that the government debt market provides a source of fixed rate exposure and second is that there is spread differential (normally positive but now negative) between swap rates and the rate in the government debt market. Thus, in theory there is a arbitrage relationship between swaps and rates that prevents swap spreads from getting too negative (with the negative value representing frictions in the banking sector). That relationship is that at a certain point it becomes very profitable for a bank to buy government debt, receive fixed, pay fixed at a higher spread, receive floating, and pay floating to receive cash to buy government debt. So linking back to the CFO above, the CFO does not need to take a view on rates but rather can rely on this arbitrage relationship to ensure that the swap rate the company receiving is not too low. There are, however, limits of arbitrage. Here the limit is the amount of leverage that a bank can employ to buy government securities (a cash obligation) to pay fixed and receive floating in a swap transaction (a cashless transaction) relative to other investment opportunities to provide a return on the same amount of equity posted to borrow to buy the government bonds. As shown above to get a 15% return on equity with a -9bps swap spread would require leverage of 15/.09 = 167x. For a 5% ROE the leverage required would be 55x. Even at the very low range of acceptable return on equity we see that the amount of leverage required is a bit extraordinary (in today’s environment), therefore it is probably safe to say that swap spreads have not yet hit a lower bound to where arbitrageurs/banks can act between bonds and the swap market to stabilize spreads. Luckily there are other relationships.
A brief note about mortgages backed by Fannie and Freddie (the vast majority in today’s environment) is that to the extent that the government or Federal reserve takes actions to “keep mortgage rates low”, ie at a low spread to government rates, these will behave like government securities in the arbitrage relationship outlined and will fail to influence swap spreads until spreads widen to a meaningful point to leverage mortgage securities to receive fixed from the mortgage market (after adjusting for all prepayment options) and pay fixed in the swap market. So an unintended consequence (see below for discussion on the general topic) of the Federal Reserve capping mortgage rates (as can be seen in the above graph from the St. Louis Fed Monetary Trends publication) is that it lowers the floor on swap spreads.
Bank Borrowers (Debtors) and Debtor - Bank Relationship:The graphs at the left taken from the St. Louis Federal Reserve Monetary Trends monthly publication give some insight into a potential cause of negative swap spreads: the decline of fixed rate borrowers. More so than from the government debt and mortgage markets, Banks source a material amount of fixed rate exposure from corporate, small business, and consumer loans. Given the recession and previous bubble in borrowings (evident left), borrowers are repaying loans and de-levering rapidly even as Banks (given swap spreads and signs of an improving economy) are getting more eager to lend as can be seen left with loosening lending standards. So we have a real sign that a critical supply of fixed payers is drying up. Normally a bank will lend at fixed + a credit spread (and recently given the crisis that credit spread has been very high) and then swap out to floating in the swaps market to receive floating which they then pay
to depositors to receive money to lend. With the decline of borrowers, it’s possible that banks are having to lend to the government in the bond market at a less attractive rate pressuring swap spreads as the banks try to maintain a profit margin.
A quick note on personal and state balance sheet repair through federal deficits which I have previously commented on. If this analysis holds, an unintended consequence of transferring private debts to the federal balance sheet is lowering (or negative) swap spreads. This is not necessarily a view on government credit quality as much as it is a result of reducing profitability of a key market intermediary- the Bank.
Bank Lenders (Bank Bond Buyers) and Lender - Bank Relationship:Banks have a outlet to pay fixed if they find themselves get long receiving fixed rates. They can issue bonds to the market which pay fixed rates. Given the obvious stress in the swap spreads market as banks get asked to pay more and more fixed rates and receive floating, it seems that banks are actually short fixed rates and so are more interested in other forms of raising cash (namely equity or deposits).
Equity Holders (Stock Holders) and Equity - Bank Relationship:Banks can raise permanent capital in the equity market (without the obligation to pay fixed rates per se) but are held accountable on their return on equity. This relationship serves to enforce on the bank that it only makes economic decisions. This contributes to the negative swap rate by imposing a limit of arbitrage in the government debt - swap rate interaction outlined above.
Depositor (included Fed) and Depositor - Bank Relationship:Just as banks can shed fixed rate exposure by issuing bonds, they can shed floating rate exposure by attracting deposits.
It is here (looking at depositor actions) that we see more signs of distortions (again from the St. Louis Fed). As noted above, in the corporate swap market we have signs that Banks are increasingly making fixed payments (and receiving floating payments) and are having trouble raising loans to source these fixed payments and are also increasingly looking for leverage in the government bond market given swap spreads but face a limit of arbitrage on leverage.
Another unintended consequence of the steep yield curve (the first being CFO’s swapping to floating) is that money is flowing out of short term (floating rate) deposits because deposits just don’t pay well in the eyes of the depositor. We see some indication of this with Libor very recently ticking up slightly (as can be seen in the graph on the left).
But it is important to remember that it is the Fed that has the largest impact on short term rates (independent of the supply of depositors to the extent that the Fed replaces depositors through open market operations) and so the effect of an unreasonably low deposit rate (that drives depositors away to other higher yielding securities or longer durations and forces the federal reserve to take open market measures to maintain low rates) manifests itself as a steep yield curve (seen left) that makes it very attractive for CFO’s to swap from fixed to floating as discussed above.
Pensions (old age insurance) and other Insurers and Insurance - Bank Relationship:The enactment of the Pension Protection Act of 2006 had the effect of requiring companies to gradually bring their retirement plans to fully funded status and maintain them that way and consequently gives strong encouragement to immunize their pension liabilities by receiving fixed rates which correspond to fixed future pension obligations. Perhaps a more tenuous link (and one which I admittedly have little evidence to support save the life expectancy chart to the left from the CDC) is that increasing life spans create longer
term liabilities in the health insurance and other markets (including an additional effect on pension liabilities). Presumably the pension issue is the dominant factor in this sector and creates a natural bid to receive fixed rates as pensions look for methods to increase portfolio duration to match liabilities.
Hedge Funds and the Hedge Fund - Bank Relationship:Lastly in the chart at the top is the hedge fund - bank relationship. Hedge funds that buy investment grade corporate debt from companies generally finance the purchases through the banking sector. They have the option to hedge interest rate exposure by swapping in one form or another to floating. Given the combination of credit spreads (at roughly 200bps) and short term interest rates (at 25bps) for a hedge fund to achieve an adequate return on equity (assumed to be 12%) without taking any interest rate risk would require leverage of 6 times (200bps * 6 = 12%). This is probably not acceptable for risk management reasons. If however funds take interest rate exposure, buy buying longer dated bonds and financing the purchase in the short term market, it is possible to achieve such a return with less than 3 times leverage. As a result it is likely that hedge funds investing in investment grade debt are electing to not hedge or to under-hedge interest rate exposure again leading to an imbalance of fixed rate receivers in the market (and an imbalance of paying fixed rates in the banking sector).
Insights, Consequences, Conclusions, Considerations and Trade Ideas:Reviewing the above discussion, I first note that credit quality of the US has not come into consideration. It can be that there are speculative positions being taken that are increasing the distortion in the swap spread market, but in my opinion this is unlikely. A key difference between the US and the so-called PIIGS - Portugal, Ireland, Italy, Greece, and Spain - is that the PIIGS cannot print their own currency of indebtedness due to the European Monetary Union. I have not explained how that can lead to negative swap rates but suffice it to say that the inability to print money in ones currency of indebtedness leads to credit risk which interferes with the government debt swap rate arbitrage relationship discussed above. The US does not have this problem and so I do not think that it is credit fears that are pushing swap spreads negative. Instead I would would guess:* Corporate hedging is likely very strong in the direction of receiving fixed due to the large
cost savings with the steep yield curve and the likely alignment with general corporate strategy to make costs variable with the recovery (spend more if the economy recovers).
* Government Bond Interest Rates are not yet high enough or the 10 Year Swap spread is not yet negative enough for the arbitrage relationship to work between these markets.
* An unintended consequence of the steep yield curve and the drive to keep mortgage rates lows is negative swap spreads.
* A reduction of general borrowings is removing an important supply of fixed rate payers which in turn leads to lower swap rates and negative swap spreads.
* An unintended consequence of taking private debts onto the public balance sheet (ie manufacturing savings) is negative swap spreads.
* Banks are at or below their lower range of desired profitability. Cost structures may be higher than historically.
* Banks are constrained by leverage and having difficulty raising deposits.* Pension funds are increasing the duration of their portfolios, competing to receive fixed.* Hedge funds are not hedging their interest rate exposure.This leads to a few themes:* The market is increasingly getting long fixed rates- that is the market is electing to receive
fixed driven largely by the slope of the yield curve.* The factors outlined above do not appear likely to change anytime soon, and therefore swap
rates are likely headed lower along with swap spreads.* There will be building pressure to flatten the yield curve as capital flows in search of higher
returns.Finally trade ideas:* Swap spreads are still not an attractive bet at this point. Risk is to even lower swap spread
especially while deflationary pressures continue.* Along these lines, due to short term deflationary pressures, receiving fixed rates is likely
going to become a crowded trade. Look for ways to take the other side....* The key to when to take a position I think is to watch loans. If lending start to pick up, swap
rates will likely rise (as will inflation). Given the crowded trade, swap rates have a potential to move sharply higher.
* An environment of rising swap rates has the potential to be positive for financial stocks as it signals a rising profitability in the business model.
* Avoid low return highly levered trades.* Long term call options on lowly levered companies could perform well as interest rates and
volatility increases. In general I like this trade even today with volatility declining as losses due to volatility drops are generally more than made up with rising equity prices.
A Brief Additional Note on Unintended Consequences and Functional Analysis:Occasionally in Bob Merton’s class at Harvard Business School I would catch hints of reference to his father, Robert King Merton, a brilliant sociologist who coined phases like self-fulfilling prophecy (which his son would reference in discussions of the rationality of bank runs) and unintended consequences. Robert K. Merton was a functionalist and presumably looked at the result of a particular structure to understand what function it was providing and thus understand its structure in a system. Thus the result was the input and the structure was the output - a demand driven analysis, which is not always the most intuitive starting point. Robert C. Merton, his son, later went to apply this same framework to understanding the financial system. Essentially bank are the way they are because that’s the structure needed in a particular society required to fulfill the needs that banks fulfill.
Arthur O’Keefe
The above graph is my structural analysis of the swap market in an attempt to understand what is driving swap spreads increasingly lower such that they are now negative at the 10 year point (they have been negative at the 30 year point for a while now). Said another way, the above is my analysis of fixed and floating rate payers and receivers in the cash and derivatives markets which I will explain below.
First a look at 10 year swap spreads (now negative) in the following graph:
The recent decline below 0 (now - 9bps as can be seen at the far right of the graph) is getting a lot of press recently. For instance here is a Bloomberg article which blames the phenomenon on corporate hedging. Later Bloomberg changed its story to say that the negative swap spreads were due to a glut in Treasury securities, and this seems to have caught on a wider following.
Personally my first reaction was that there must be some structural stress going on with the market, but that does not necessarily mean that the stress is due to a view of government credit quality relative to corporate credit quality. The graph at the left, though, shows swap spreads around the world, and one can certainly see that there is a strong correlation between negative swap spreads and countries having deficit problems. Correlation, though, does not equate to causality. Also what might be causing negative swap spreads in one market does
not necessarily cause them in another.
To really dig to the bottom of this, I looked at the swap system using a framework developed by one of my professor’s at Harvard Business School, Robert C. Merton (not to be confused with Robert K. Merton, his father and acclaimed sociologist whom I will discuss as well at the end of this entry). Bob (Robert C.) Merton is best known for winning the Nobel Prize in Economics for his insight of using Ito calculus to price options (ie developing the continuos time implementation of the Black-Scholes option pricing formula) and later for participating in the rise and fall of Long Term Capital Management. So since Merton already has a Nobel and a bit of fame/notoriety, his more recent work on things like pensions (with Zvi Bodie) and structures of financial systems has not garnered much attention. In some ways, though, his more recent work is even more impactful, in my opinion, than the closed form options pricing equation (Black-Scholes) which is widely used but nevertheless confined to the universe of options and derivatives traders. In any case, Merton with Bodie (link here:) postulates that the outputs of a financial system are dependent on financial institutions and intermediaries that evolve with the politics, customs, and behaviors of a society and so apparent distortions in the financial market would therefore be partly due to a structural deficiency or friction within the institutions.
So it can be that government deficits do indeed lead to negative swap spreads, but it is not at all clear why that should be the case and how it actually happens. Where exactly is the stress of government deficits showing up and who is really bearing the risk? Is it in the banks again as zero hedge postulates? Or is it somewhere else?
Hence the graph at the top of this post dissecting the sources of fixed and floating rate exposures in the market. Along the lines of Merton’s framework, the bank is seen as an intermediary in the whole process and acts only to transmit risk between entities, though it does introduce a friction in the form of a spread that it charges for its risk transmission service. So let’s translate this intricate graph:
Corporation Block and Corporation - Bank Relationship:Starting at the bank/corporate relationship (since that was where Bloomberg originally postulated the problem started and where the stress was most evident) we see that corporations issue bonds (mostly) to hedge funds and insurers paying a fixed rate - assume for 10 years to keep with the analysis of swap spreads. Bloomberg argued that corporations then enter into a swap arrangement with Banks to receive fixed and pay floating rates for the term of the bond issuance (10 years in this case).
Before analyzing how or why a Bank would do this, let’s think like a corporate treasurer/CFO in today’s interest rate environment. Specifically let’s think like the CFO of a generic BBB corporation today. The iBoxx Domestic Corporate BBB Spread to Libor index shown to the left shows a BBB credit spread of 1.92%. This is the credit spread to swap rates that a corporation of BBB credit quality pays and is generally in line with what one sees in the market today. 10 year swap rates (also shown on the left) shows that banks borrow for 10 years at 3.71% (the 10 year Libor or Swap rate) so the cost of borrowing to the treasurer is 1.92%+3.71% = 5.63%.
So if the CFO issues a bond and does nothing else, he has locked up 10 year financing at 5.63%. But is there anything else the CFO can do to lower borrowing costs today that might also strategically fit in with the companies revenue forecasts? Yes, the CFO can swap from fixed to floating by agreeing to pay 3 month Libor resetting every 3 months for the next 10 years and in return receive the 10 year Swap rate. 3 month libor is today .28% annualized (as can be seen in the chart at the left), so if the CFO does this, borrowing costs then become 5.63% - 3.71% + .28% = 2.2%. This is a 60% reduction in costs. And what risk is being taken for this reduction? Mainly the risk that short term rates increase. But under what circumstances will short term rates increase? Probably only a recovery, and in a recovery revenues will rise before and faster than interest rates (given the large amount of excess capacity in the system, the recovery will be well underway before rates rise), so from a business perspective, this is manageable. In the meantime if the recovery is
delayed, the company continues to pay 60% less in interest than it would under a 10 year fixed arrangement. So really, the decision is a “no brainer” for the CFO. Swap to floating.
Notice in this entire analysis, the CFO does not care where 10 year government rates are trading. Actually as can be seen in the chart on the left, investing in a 10 year government bonds will pay 3.83%, whereas the bank will only pay 3.71% as noted above, so the CFO will receive 10bps less than investing in government bonds, but the CFO still does the deal because the CFO is not looking to invest money - rather merely switch from a fixed rate to floating. Said
another way, the CFO is not concerned that the fixed rate the company will receive is less that the rate that the company would receive if the company because the CFO is not looking to deploy cash but is rather looking at 2 borrowing options, and in this case the CFO is making the more rational decision and swaps. The CFO’s actions will then push the swap market lower, but nevertheless the swap market will remain attractive for the next CFO who will do the same trade. So absent some other relationship (probably an arbitrage relationship as discussed below) with other actors the swap spread will continue lower until it reaches the point of indifference between swapping from fixed to floating for the marginal corporate borrower. But, there are other relationships as we continue around the diagram at the top of the page.
Government Debt (including mortgages) Block and Government Debt - Bank Relationship:So continuing right in the graph at the top (using Merton’s framework of analyzing a bank as an intermediary as opposed to a risk taking entity) we look at the Bank’s actions in the government debt market and how these might affect swap rates. There are two items which are critical. First is that the government debt market provides a source of fixed rate exposure and second is that there is spread differential (normally positive but now negative) between swap rates and the rate in the government debt market. Thus, in theory there is a arbitrage relationship between swaps and rates that prevents swap spreads from getting too negative (with the negative value representing frictions in the banking sector). That relationship is that at a certain point it becomes very profitable for a bank to buy government debt, receive fixed, pay fixed at a higher spread, receive floating, and pay floating to receive cash to buy government debt. So linking back to the CFO above, the CFO does not need to take a view on rates but rather can rely on this arbitrage relationship to ensure that the swap rate the company receiving is not too low. There are, however, limits of arbitrage. Here the limit is the amount of leverage that a bank can employ to buy government securities (a cash obligation) to pay fixed and receive floating in a swap transaction (a cashless transaction) relative to other investment opportunities to provide a return on the same amount of equity posted to borrow to buy the government bonds. As shown above to get a 15% return on equity with a -9bps swap spread would require leverage of 15/.09 = 167x. For a 5% ROE the leverage required would be 55x. Even at the very low range of acceptable return on equity we see that the amount of leverage required is a bit extraordinary (in today’s environment), therefore it is probably safe to say that swap spreads have not yet hit a lower bound to where arbitrageurs/banks can act between bonds and the swap market to stabilize spreads. Luckily there are other relationships.
A brief note about mortgages backed by Fannie and Freddie (the vast majority in today’s environment) is that to the extent that the government or Federal reserve takes actions to “keep mortgage rates low”, ie at a low spread to government rates, these will behave like government securities in the arbitrage relationship outlined and will fail to influence swap spreads until spreads widen to a meaningful point to leverage mortgage securities to receive fixed from the mortgage market (after adjusting for all prepayment options) and pay fixed in the swap market. So an unintended consequence (see below for discussion on the general topic) of the Federal Reserve capping mortgage rates (as can be seen in the above graph from the St. Louis Fed Monetary Trends publication) is that it lowers the floor on swap spreads.
Bank Borrowers (Debtors) and Debtor - Bank Relationship:The graphs at the left taken from the St. Louis Federal Reserve Monetary Trends monthly publication give some insight into a potential cause of negative swap spreads: the decline of fixed rate borrowers. More so than from the government debt and mortgage markets, Banks source a material amount of fixed rate exposure from corporate, small business, and consumer loans. Given the recession and previous bubble in borrowings (evident left), borrowers are repaying loans and de-levering rapidly even as Banks (given swap spreads and signs of an improving economy) are getting more eager to lend as can be seen left with loosening lending standards. So we have a real sign that a critical supply of fixed payers is drying up. Normally a bank will lend at fixed + a credit spread (and recently given the crisis that credit spread has been very high) and then swap out to floating in the swaps market to receive floating which they then pay
to depositors to receive money to lend. With the decline of borrowers, it’s possible that banks are having to lend to the government in the bond market at a less attractive rate pressuring swap spreads as the banks try to maintain a profit margin.
A quick note on personal and state balance sheet repair through federal deficits which I have previously commented on. If this analysis holds, an unintended consequence of transferring private debts to the federal balance sheet is lowering (or negative) swap spreads. This is not necessarily a view on government credit quality as much as it is a result of reducing profitability of a key market intermediary- the Bank.
Bank Lenders (Bank Bond Buyers) and Lender - Bank Relationship:Banks have a outlet to pay fixed if they find themselves get long receiving fixed rates. They can issue bonds to the market which pay fixed rates. Given the obvious stress in the swap spreads market as banks get asked to pay more and more fixed rates and receive floating, it seems that banks are actually short fixed rates and so are more interested in other forms of raising cash (namely equity or deposits).
Equity Holders (Stock Holders) and Equity - Bank Relationship:Banks can raise permanent capital in the equity market (without the obligation to pay fixed rates per se) but are held accountable on their return on equity. This relationship serves to enforce on the bank that it only makes economic decisions. This contributes to the negative swap rate by imposing a limit of arbitrage in the government debt - swap rate interaction outlined above.
Depositor (included Fed) and Depositor - Bank Relationship:Just as banks can shed fixed rate exposure by issuing bonds, they can shed floating rate exposure by attracting deposits.
It is here (looking at depositor actions) that we see more signs of distortions (again from the St. Louis Fed). As noted above, in the corporate swap market we have signs that Banks are increasingly making fixed payments (and receiving floating payments) and are having trouble raising loans to source these fixed payments and are also increasingly looking for leverage in the government bond market given swap spreads but face a limit of arbitrage on leverage.
Another unintended consequence of the steep yield curve (the first being CFO’s swapping to floating) is that money is flowing out of short term (floating rate) deposits because deposits just don’t pay well in the eyes of the depositor. We see some indication of this with Libor very recently ticking up slightly (as can be seen in the graph on the left).
But it is important to remember that it is the Fed that has the largest impact on short term rates (independent of the supply of depositors to the extent that the Fed replaces depositors through open market operations) and so the effect of an unreasonably low deposit rate (that drives depositors away to other higher yielding securities or longer durations and forces the federal reserve to take open market measures to maintain low rates) manifests itself as a steep yield curve (seen left) that makes it very attractive for CFO’s to swap from fixed to floating as discussed above.
Pensions (old age insurance) and other Insurers and Insurance - Bank Relationship:The enactment of the Pension Protection Act of 2006 had the effect of requiring companies to gradually bring their retirement plans to fully funded status and maintain them that way and consequently gives strong encouragement to immunize their pension liabilities by receiving fixed rates which correspond to fixed future pension obligations. Perhaps a more tenuous link (and one which I admittedly have little evidence to support save the life expectancy chart to the left from the CDC) is that increasing life spans create longer
term liabilities in the health insurance and other markets (including an additional effect on pension liabilities). Presumably the pension issue is the dominant factor in this sector and creates a natural bid to receive fixed rates as pensions look for methods to increase portfolio duration to match liabilities.
Hedge Funds and the Hedge Fund - Bank Relationship:Lastly in the chart at the top is the hedge fund - bank relationship. Hedge funds that buy investment grade corporate debt from companies generally finance the purchases through the banking sector. They have the option to hedge interest rate exposure by swapping in one form or another to floating. Given the combination of credit spreads (at roughly 200bps) and short term interest rates (at 25bps) for a hedge fund to achieve an adequate return on equity (assumed to be 12%) without taking any interest rate risk would require leverage of 6 times (200bps * 6 = 12%). This is probably not acceptable for risk management reasons. If however funds take interest rate exposure, buy buying longer dated bonds and financing the purchase in the short term market, it is possible to achieve such a return with less than 3 times leverage. As a result it is likely that hedge funds investing in investment grade debt are electing to not hedge or to under-hedge interest rate exposure again leading to an imbalance of fixed rate receivers in the market (and an imbalance of paying fixed rates in the banking sector).
Insights, Consequences, Conclusions, Considerations and Trade Ideas:Reviewing the above discussion, I first note that credit quality of the US has not come into consideration. It can be that there are speculative positions being taken that are increasing the distortion in the swap spread market, but in my opinion this is unlikely. A key difference between the US and the so-called PIIGS - Portugal, Ireland, Italy, Greece, and Spain - is that the PIIGS cannot print their own currency of indebtedness due to the European Monetary Union. I have not explained how that can lead to negative swap rates but suffice it to say that the inability to print money in ones currency of indebtedness leads to credit risk which interferes with the government debt swap rate arbitrage relationship discussed above. The US does not have this problem and so I do not think that it is credit fears that are pushing swap spreads negative. Instead I would would guess:* Corporate hedging is likely very strong in the direction of receiving fixed due to the large
cost savings with the steep yield curve and the likely alignment with general corporate strategy to make costs variable with the recovery (spend more if the economy recovers).
* Government Bond Interest Rates are not yet high enough or the 10 Year Swap spread is not yet negative enough for the arbitrage relationship to work between these markets.
* An unintended consequence of the steep yield curve and the drive to keep mortgage rates lows is negative swap spreads.
* A reduction of general borrowings is removing an important supply of fixed rate payers which in turn leads to lower swap rates and negative swap spreads.
* An unintended consequence of taking private debts onto the public balance sheet (ie manufacturing savings) is negative swap spreads.
* Banks are at or below their lower range of desired profitability. Cost structures may be higher than historically.
* Banks are constrained by leverage and having difficulty raising deposits.* Pension funds are increasing the duration of their portfolios, competing to receive fixed.* Hedge funds are not hedging their interest rate exposure.This leads to a few themes:* The market is increasingly getting long fixed rates- that is the market is electing to receive
fixed driven largely by the slope of the yield curve.* The factors outlined above do not appear likely to change anytime soon, and therefore swap
rates are likely headed lower along with swap spreads.* There will be building pressure to flatten the yield curve as capital flows in search of higher
returns.Finally trade ideas:* Swap spreads are still not an attractive bet at this point. Risk is to even lower swap spread
especially while deflationary pressures continue.* Along these lines, due to short term deflationary pressures, receiving fixed rates is likely
going to become a crowded trade. Look for ways to take the other side....* The key to when to take a position I think is to watch loans. If lending start to pick up, swap
rates will likely rise (as will inflation). Given the crowded trade, swap rates have a potential to move sharply higher.
* An environment of rising swap rates has the potential to be positive for financial stocks as it signals a rising profitability in the business model.
* Avoid low return highly levered trades.* Long term call options on lowly levered companies could perform well as interest rates and
volatility increases. In general I like this trade even today with volatility declining as losses due to volatility drops are generally more than made up with rising equity prices.
A Brief Additional Note on Unintended Consequences and Functional Analysis:Occasionally in Bob Merton’s class at Harvard Business School I would catch hints of reference to his father, Robert King Merton, a brilliant sociologist who coined phases like self-fulfilling prophecy (which his son would reference in discussions of the rationality of bank runs) and unintended consequences. Robert K. Merton was a functionalist and presumably looked at the result of a particular structure to understand what function it was providing and thus understand its structure in a system. Thus the result was the input and the structure was the output - a demand driven analysis, which is not always the most intuitive starting point. Robert C. Merton, his son, later went to apply this same framework to understanding the financial system. Essentially bank are the way they are because that’s the structure needed in a particular society required to fulfill the needs that banks fulfill.
Arthur O’Keefe
The above graph is my structural analysis of the swap market in an attempt to understand what is driving swap spreads increasingly lower such that they are now negative at the 10 year point (they have been negative at the 30 year point for a while now). Said another way, the above is my analysis of fixed and floating rate payers and receivers in the cash and derivatives markets which I will explain below.
First a look at 10 year swap spreads (now negative) in the following graph:
The recent decline below 0 (now - 9bps as can be seen at the far right of the graph) is getting a lot of press recently. For instance here is a Bloomberg article which blames the phenomenon on corporate hedging. Later Bloomberg changed its story to say that the negative swap spreads were due to a glut in Treasury securities, and this seems to have caught on a wider following.
Personally my first reaction was that there must be some structural stress going on with the market, but that does not necessarily mean that the stress is due to a view of government credit quality relative to corporate credit quality. The graph at the left, though, shows swap spreads around the world, and one can certainly see that there is a strong correlation between negative swap spreads and countries having deficit problems. Correlation, though, does not equate to causality. Also what might be causing negative swap spreads in one market does
not necessarily cause them in another.
To really dig to the bottom of this, I looked at the swap system using a framework developed by one of my professor’s at Harvard Business School, Robert C. Merton (not to be confused with Robert K. Merton, his father and acclaimed sociologist whom I will discuss as well at the end of this entry). Bob (Robert C.) Merton is best known for winning the Nobel Prize in Economics for his insight of using Ito calculus to price options (ie developing the continuos time implementation of the Black-Scholes option pricing formula) and later for participating in the rise and fall of Long Term Capital Management. So since Merton already has a Nobel and a bit of fame/notoriety, his more recent work on things like pensions (with Zvi Bodie) and structures of financial systems has not garnered much attention. In some ways, though, his more recent work is even more impactful, in my opinion, than the closed form options pricing equation (Black-Scholes) which is widely used but nevertheless confined to the universe of options and derivatives traders. In any case, Merton with Bodie (link here:) postulates that the outputs of a financial system are dependent on financial institutions and intermediaries that evolve with the politics, customs, and behaviors of a society and so apparent distortions in the financial market would therefore be partly due to a structural deficiency or friction within the institutions.
So it can be that government deficits do indeed lead to negative swap spreads, but it is not at all clear why that should be the case and how it actually happens. Where exactly is the stress of government deficits showing up and who is really bearing the risk? Is it in the banks again as zero hedge postulates? Or is it somewhere else?
Hence the graph at the top of this post dissecting the sources of fixed and floating rate exposures in the market. Along the lines of Merton’s framework, the bank is seen as an intermediary in the whole process and acts only to transmit risk between entities, though it does introduce a friction in the form of a spread that it charges for its risk transmission service. So let’s translate this intricate graph:
Corporation Block and Corporation - Bank Relationship:Starting at the bank/corporate relationship (since that was where Bloomberg originally postulated the problem started and where the stress was most evident) we see that corporations issue bonds (mostly) to hedge funds and insurers paying a fixed rate - assume for 10 years to keep with the analysis of swap spreads. Bloomberg argued that corporations then enter into a swap arrangement with Banks to receive fixed and pay floating rates for the term of the bond issuance (10 years in this case).
Before analyzing how or why a Bank would do this, let’s think like a corporate treasurer/CFO in today’s interest rate environment. Specifically let’s think like the CFO of a generic BBB corporation today. The iBoxx Domestic Corporate BBB Spread to Libor index shown to the left shows a BBB credit spread of 1.92%. This is the credit spread to swap rates that a corporation of BBB credit quality pays and is generally in line with what one sees in the market today. 10 year swap rates (also shown on the left) shows that banks borrow for 10 years at 3.71% (the 10 year Libor or Swap rate) so the cost of borrowing to the treasurer is 1.92%+3.71% = 5.63%.
So if the CFO issues a bond and does nothing else, he has locked up 10 year financing at 5.63%. But is there anything else the CFO can do to lower borrowing costs today that might also strategically fit in with the companies revenue forecasts? Yes, the CFO can swap from fixed to floating by agreeing to pay 3 month Libor resetting every 3 months for the next 10 years and in return receive the 10 year Swap rate. 3 month libor is today .28% annualized (as can be seen in the chart at the left), so if the CFO does this, borrowing costs then become 5.63% - 3.71% + .28% = 2.2%. This is a 60% reduction in costs. And what risk is being taken for this reduction? Mainly the risk that short term rates increase. But under what circumstances will short term rates increase? Probably only a recovery, and in a recovery revenues will rise before and faster than interest rates (given the large amount of excess capacity in the system, the recovery will be well underway before rates rise), so from a business perspective, this is manageable. In the meantime if the recovery is
delayed, the company continues to pay 60% less in interest than it would under a 10 year fixed arrangement. So really, the decision is a “no brainer” for the CFO. Swap to floating.
Notice in this entire analysis, the CFO does not care where 10 year government rates are trading. Actually as can be seen in the chart on the left, investing in a 10 year government bonds will pay 3.83%, whereas the bank will only pay 3.71% as noted above, so the CFO will receive 10bps less than investing in government bonds, but the CFO still does the deal because the CFO is not looking to invest money - rather merely switch from a fixed rate to floating. Said
another way, the CFO is not concerned that the fixed rate the company will receive is less that the rate that the company would receive if the company because the CFO is not looking to deploy cash but is rather looking at 2 borrowing options, and in this case the CFO is making the more rational decision and swaps. The CFO’s actions will then push the swap market lower, but nevertheless the swap market will remain attractive for the next CFO who will do the same trade. So absent some other relationship (probably an arbitrage relationship as discussed below) with other actors the swap spread will continue lower until it reaches the point of indifference between swapping from fixed to floating for the marginal corporate borrower. But, there are other relationships as we continue around the diagram at the top of the page.
Government Debt (including mortgages) Block and Government Debt - Bank Relationship:So continuing right in the graph at the top (using Merton’s framework of analyzing a bank as an intermediary as opposed to a risk taking entity) we look at the Bank’s actions in the government debt market and how these might affect swap rates. There are two items which are critical. First is that the government debt market provides a source of fixed rate exposure and second is that there is spread differential (normally positive but now negative) between swap rates and the rate in the government debt market. Thus, in theory there is a arbitrage relationship between swaps and rates that prevents swap spreads from getting too negative (with the negative value representing frictions in the banking sector). That relationship is that at a certain point it becomes very profitable for a bank to buy government debt, receive fixed, pay fixed at a higher spread, receive floating, and pay floating to receive cash to buy government debt. So linking back to the CFO above, the CFO does not need to take a view on rates but rather can rely on this arbitrage relationship to ensure that the swap rate the company receiving is not too low. There are, however, limits of arbitrage. Here the limit is the amount of leverage that a bank can employ to buy government securities (a cash obligation) to pay fixed and receive floating in a swap transaction (a cashless transaction) relative to other investment opportunities to provide a return on the same amount of equity posted to borrow to buy the government bonds. As shown above to get a 15% return on equity with a -9bps swap spread would require leverage of 15/.09 = 167x. For a 5% ROE the leverage required would be 55x. Even at the very low range of acceptable return on equity we see that the amount of leverage required is a bit extraordinary (in today’s environment), therefore it is probably safe to say that swap spreads have not yet hit a lower bound to where arbitrageurs/banks can act between bonds and the swap market to stabilize spreads. Luckily there are other relationships.
A brief note about mortgages backed by Fannie and Freddie (the vast majority in today’s environment) is that to the extent that the government or Federal reserve takes actions to “keep mortgage rates low”, ie at a low spread to government rates, these will behave like government securities in the arbitrage relationship outlined and will fail to influence swap spreads until spreads widen to a meaningful point to leverage mortgage securities to receive fixed from the mortgage market (after adjusting for all prepayment options) and pay fixed in the swap market. So an unintended consequence (see below for discussion on the general topic) of the Federal Reserve capping mortgage rates (as can be seen in the above graph from the St. Louis Fed Monetary Trends publication) is that it lowers the floor on swap spreads.
Bank Borrowers (Debtors) and Debtor - Bank Relationship:The graphs at the left taken from the St. Louis Federal Reserve Monetary Trends monthly publication give some insight into a potential cause of negative swap spreads: the decline of fixed rate borrowers. More so than from the government debt and mortgage markets, Banks source a material amount of fixed rate exposure from corporate, small business, and consumer loans. Given the recession and previous bubble in borrowings (evident left), borrowers are repaying loans and de-levering rapidly even as Banks (given swap spreads and signs of an improving economy) are getting more eager to lend as can be seen left with loosening lending standards. So we have a real sign that a critical supply of fixed payers is drying up. Normally a bank will lend at fixed + a credit spread (and recently given the crisis that credit spread has been very high) and then swap out to floating in the swaps market to receive floating which they then pay
to depositors to receive money to lend. With the decline of borrowers, it’s possible that banks are having to lend to the government in the bond market at a less attractive rate pressuring swap spreads as the banks try to maintain a profit margin.
A quick note on personal and state balance sheet repair through federal deficits which I have previously commented on. If this analysis holds, an unintended consequence of transferring private debts to the federal balance sheet is lowering (or negative) swap spreads. This is not necessarily a view on government credit quality as much as it is a result of reducing profitability of a key market intermediary- the Bank.
Bank Lenders (Bank Bond Buyers) and Lender - Bank Relationship:Banks have a outlet to pay fixed if they find themselves get long receiving fixed rates. They can issue bonds to the market which pay fixed rates. Given the obvious stress in the swap spreads market as banks get asked to pay more and more fixed rates and receive floating, it seems that banks are actually short fixed rates and so are more interested in other forms of raising cash (namely equity or deposits).
Equity Holders (Stock Holders) and Equity - Bank Relationship:Banks can raise permanent capital in the equity market (without the obligation to pay fixed rates per se) but are held accountable on their return on equity. This relationship serves to enforce on the bank that it only makes economic decisions. This contributes to the negative swap rate by imposing a limit of arbitrage in the government debt - swap rate interaction outlined above.
Depositor (included Fed) and Depositor - Bank Relationship:Just as banks can shed fixed rate exposure by issuing bonds, they can shed floating rate exposure by attracting deposits.
It is here (looking at depositor actions) that we see more signs of distortions (again from the St. Louis Fed). As noted above, in the corporate swap market we have signs that Banks are increasingly making fixed payments (and receiving floating payments) and are having trouble raising loans to source these fixed payments and are also increasingly looking for leverage in the government bond market given swap spreads but face a limit of arbitrage on leverage.
Another unintended consequence of the steep yield curve (the first being CFO’s swapping to floating) is that money is flowing out of short term (floating rate) deposits because deposits just don’t pay well in the eyes of the depositor. We see some indication of this with Libor very recently ticking up slightly (as can be seen in the graph on the left).
But it is important to remember that it is the Fed that has the largest impact on short term rates (independent of the supply of depositors to the extent that the Fed replaces depositors through open market operations) and so the effect of an unreasonably low deposit rate (that drives depositors away to other higher yielding securities or longer durations and forces the federal reserve to take open market measures to maintain low rates) manifests itself as a steep yield curve (seen left) that makes it very attractive for CFO’s to swap from fixed to floating as discussed above.
Pensions (old age insurance) and other Insurers and Insurance - Bank Relationship:The enactment of the Pension Protection Act of 2006 had the effect of requiring companies to gradually bring their retirement plans to fully funded status and maintain them that way and consequently gives strong encouragement to immunize their pension liabilities by receiving fixed rates which correspond to fixed future pension obligations. Perhaps a more tenuous link (and one which I admittedly have little evidence to support save the life expectancy chart to the left from the CDC) is that increasing life spans create longer
term liabilities in the health insurance and other markets (including an additional effect on pension liabilities). Presumably the pension issue is the dominant factor in this sector and creates a natural bid to receive fixed rates as pensions look for methods to increase portfolio duration to match liabilities.
Hedge Funds and the Hedge Fund - Bank Relationship:Lastly in the chart at the top is the hedge fund - bank relationship. Hedge funds that buy investment grade corporate debt from companies generally finance the purchases through the banking sector. They have the option to hedge interest rate exposure by swapping in one form or another to floating. Given the combination of credit spreads (at roughly 200bps) and short term interest rates (at 25bps) for a hedge fund to achieve an adequate return on equity (assumed to be 12%) without taking any interest rate risk would require leverage of 6 times (200bps * 6 = 12%). This is probably not acceptable for risk management reasons. If however funds take interest rate exposure, buy buying longer dated bonds and financing the purchase in the short term market, it is possible to achieve such a return with less than 3 times leverage. As a result it is likely that hedge funds investing in investment grade debt are electing to not hedge or to under-hedge interest rate exposure again leading to an imbalance of fixed rate receivers in the market (and an imbalance of paying fixed rates in the banking sector).
Insights, Consequences, Conclusions, Considerations and Trade Ideas:Reviewing the above discussion, I first note that credit quality of the US has not come into consideration. It can be that there are speculative positions being taken that are increasing the distortion in the swap spread market, but in my opinion this is unlikely. A key difference between the US and the so-called PIIGS - Portugal, Ireland, Italy, Greece, and Spain - is that the PIIGS cannot print their own currency of indebtedness due to the European Monetary Union. I have not explained how that can lead to negative swap rates but suffice it to say that the inability to print money in ones currency of indebtedness leads to credit risk which interferes with the government debt swap rate arbitrage relationship discussed above. The US does not have this problem and so I do not think that it is credit fears that are pushing swap spreads negative. Instead I would would guess:* Corporate hedging is likely very strong in the direction of receiving fixed due to the large
cost savings with the steep yield curve and the likely alignment with general corporate strategy to make costs variable with the recovery (spend more if the economy recovers).
* Government Bond Interest Rates are not yet high enough or the 10 Year Swap spread is not yet negative enough for the arbitrage relationship to work between these markets.
* An unintended consequence of the steep yield curve and the drive to keep mortgage rates lows is negative swap spreads.
* A reduction of general borrowings is removing an important supply of fixed rate payers which in turn leads to lower swap rates and negative swap spreads.
* An unintended consequence of taking private debts onto the public balance sheet (ie manufacturing savings) is negative swap spreads.
* Banks are at or below their lower range of desired profitability. Cost structures may be higher than historically.
* Banks are constrained by leverage and having difficulty raising deposits.* Pension funds are increasing the duration of their portfolios, competing to receive fixed.* Hedge funds are not hedging their interest rate exposure.This leads to a few themes:* The market is increasingly getting long fixed rates- that is the market is electing to receive
fixed driven largely by the slope of the yield curve.* The factors outlined above do not appear likely to change anytime soon, and therefore swap
rates are likely headed lower along with swap spreads.* There will be building pressure to flatten the yield curve as capital flows in search of higher
returns.Finally trade ideas:* Swap spreads are still not an attractive bet at this point. Risk is to even lower swap spread
especially while deflationary pressures continue.* Along these lines, due to short term deflationary pressures, receiving fixed rates is likely
going to become a crowded trade. Look for ways to take the other side....* The key to when to take a position I think is to watch loans. If lending start to pick up, swap
rates will likely rise (as will inflation). Given the crowded trade, swap rates have a potential to move sharply higher.
* An environment of rising swap rates has the potential to be positive for financial stocks as it signals a rising profitability in the business model.
* Avoid low return highly levered trades.* Long term call options on lowly levered companies could perform well as interest rates and
volatility increases. In general I like this trade even today with volatility declining as losses due to volatility drops are generally more than made up with rising equity prices.
A Brief Additional Note on Unintended Consequences and Functional Analysis:Occasionally in Bob Merton’s class at Harvard Business School I would catch hints of reference to his father, Robert King Merton, a brilliant sociologist who coined phases like self-fulfilling prophecy (which his son would reference in discussions of the rationality of bank runs) and unintended consequences. Robert K. Merton was a functionalist and presumably looked at the result of a particular structure to understand what function it was providing and thus understand its structure in a system. Thus the result was the input and the structure was the output - a demand driven analysis, which is not always the most intuitive starting point. Robert C. Merton, his son, later went to apply this same framework to understanding the financial system. Essentially bank are the way they are because that’s the structure needed in a particular society required to fulfill the needs that banks fulfill.
Arthur O’Keefe
The above graph is my structural analysis of the swap market in an attempt to understand what is driving swap spreads increasingly lower such that they are now negative at the 10 year point (they have been negative at the 30 year point for a while now). Said another way, the above is my analysis of fixed and floating rate payers and receivers in the cash and derivatives markets which I will explain below.
First a look at 10 year swap spreads (now negative) in the following graph:
The recent decline below 0 (now - 9bps as can be seen at the far right of the graph) is getting a lot of press recently. For instance here is a Bloomberg article which blames the phenomenon on corporate hedging. Later Bloomberg changed its story to say that the negative swap spreads were due to a glut in Treasury securities, and this seems to have caught on a wider following.
Personally my first reaction was that there must be some structural stress going on with the market, but that does not necessarily mean that the stress is due to a view of government credit quality relative to corporate credit quality. The graph at the left, though, shows swap spreads around the world, and one can certainly see that there is a strong correlation between negative swap spreads and countries having deficit problems. Correlation, though, does not equate to causality. Also what might be causing negative swap spreads in one market does
not necessarily cause them in another.
To really dig to the bottom of this, I looked at the swap system using a framework developed by one of my professor’s at Harvard Business School, Robert C. Merton (not to be confused with Robert K. Merton, his father and acclaimed sociologist whom I will discuss as well at the end of this entry). Bob (Robert C.) Merton is best known for winning the Nobel Prize in Economics for his insight of using Ito calculus to price options (ie developing the continuos time implementation of the Black-Scholes option pricing formula) and later for participating in the rise and fall of Long Term Capital Management. So since Merton already has a Nobel and a bit of fame/notoriety, his more recent work on things like pensions (with Zvi Bodie) and structures of financial systems has not garnered much attention. In some ways, though, his more recent work is even more impactful, in my opinion, than the closed form options pricing equation (Black-Scholes) which is widely used but nevertheless confined to the universe of options and derivatives traders. In any case, Merton with Bodie (link here:) postulates that the outputs of a financial system are dependent on financial institutions and intermediaries that evolve with the politics, customs, and behaviors of a society and so apparent distortions in the financial market would therefore be partly due to a structural deficiency or friction within the institutions.
So it can be that government deficits do indeed lead to negative swap spreads, but it is not at all clear why that should be the case and how it actually happens. Where exactly is the stress of government deficits showing up and who is really bearing the risk? Is it in the banks again as zero hedge postulates? Or is it somewhere else?
Hence the graph at the top of this post dissecting the sources of fixed and floating rate exposures in the market. Along the lines of Merton’s framework, the bank is seen as an intermediary in the whole process and acts only to transmit risk between entities, though it does introduce a friction in the form of a spread that it charges for its risk transmission service. So let’s translate this intricate graph:
Corporation Block and Corporation - Bank Relationship:Starting at the bank/corporate relationship (since that was where Bloomberg originally postulated the problem started and where the stress was most evident) we see that corporations issue bonds (mostly) to hedge funds and insurers paying a fixed rate - assume for 10 years to keep with the analysis of swap spreads. Bloomberg argued that corporations then enter into a swap arrangement with Banks to receive fixed and pay floating rates for the term of the bond issuance (10 years in this case).
Before analyzing how or why a Bank would do this, let’s think like a corporate treasurer/CFO in today’s interest rate environment. Specifically let’s think like the CFO of a generic BBB corporation today. The iBoxx Domestic Corporate BBB Spread to Libor index shown to the left shows a BBB credit spread of 1.92%. This is the credit spread to swap rates that a corporation of BBB credit quality pays and is generally in line with what one sees in the market today. 10 year swap rates (also shown on the left) shows that banks borrow for 10 years at 3.71% (the 10 year Libor or Swap rate) so the cost of borrowing to the treasurer is 1.92%+3.71% = 5.63%.
So if the CFO issues a bond and does nothing else, he has locked up 10 year financing at 5.63%. But is there anything else the CFO can do to lower borrowing costs today that might also strategically fit in with the companies revenue forecasts? Yes, the CFO can swap from fixed to floating by agreeing to pay 3 month Libor resetting every 3 months for the next 10 years and in return receive the 10 year Swap rate. 3 month libor is today .28% annualized (as can be seen in the chart at the left), so if the CFO does this, borrowing costs then become 5.63% - 3.71% + .28% = 2.2%. This is a 60% reduction in costs. And what risk is being taken for this reduction? Mainly the risk that short term rates increase. But under what circumstances will short term rates increase? Probably only a recovery, and in a recovery revenues will rise before and faster than interest rates (given the large amount of excess capacity in the system, the recovery will be well underway before rates rise), so from a business perspective, this is manageable. In the meantime if the recovery is
delayed, the company continues to pay 60% less in interest than it would under a 10 year fixed arrangement. So really, the decision is a “no brainer” for the CFO. Swap to floating.
Notice in this entire analysis, the CFO does not care where 10 year government rates are trading. Actually as can be seen in the chart on the left, investing in a 10 year government bonds will pay 3.83%, whereas the bank will only pay 3.71% as noted above, so the CFO will receive 10bps less than investing in government bonds, but the CFO still does the deal because the CFO is not looking to invest money - rather merely switch from a fixed rate to floating. Said
another way, the CFO is not concerned that the fixed rate the company will receive is less that the rate that the company would receive if the company because the CFO is not looking to deploy cash but is rather looking at 2 borrowing options, and in this case the CFO is making the more rational decision and swaps. The CFO’s actions will then push the swap market lower, but nevertheless the swap market will remain attractive for the next CFO who will do the same trade. So absent some other relationship (probably an arbitrage relationship as discussed below) with other actors the swap spread will continue lower until it reaches the point of indifference between swapping from fixed to floating for the marginal corporate borrower. But, there are other relationships as we continue around the diagram at the top of the page.
Government Debt (including mortgages) Block and Government Debt - Bank Relationship:So continuing right in the graph at the top (using Merton’s framework of analyzing a bank as an intermediary as opposed to a risk taking entity) we look at the Bank’s actions in the government debt market and how these might affect swap rates. There are two items which are critical. First is that the government debt market provides a source of fixed rate exposure and second is that there is spread differential (normally positive but now negative) between swap rates and the rate in the government debt market. Thus, in theory there is a arbitrage relationship between swaps and rates that prevents swap spreads from getting too negative (with the negative value representing frictions in the banking sector). That relationship is that at a certain point it becomes very profitable for a bank to buy government debt, receive fixed, pay fixed at a higher spread, receive floating, and pay floating to receive cash to buy government debt. So linking back to the CFO above, the CFO does not need to take a view on rates but rather can rely on this arbitrage relationship to ensure that the swap rate the company receiving is not too low. There are, however, limits of arbitrage. Here the limit is the amount of leverage that a bank can employ to buy government securities (a cash obligation) to pay fixed and receive floating in a swap transaction (a cashless transaction) relative to other investment opportunities to provide a return on the same amount of equity posted to borrow to buy the government bonds. As shown above to get a 15% return on equity with a -9bps swap spread would require leverage of 15/.09 = 167x. For a 5% ROE the leverage required would be 55x. Even at the very low range of acceptable return on equity we see that the amount of leverage required is a bit extraordinary (in today’s environment), therefore it is probably safe to say that swap spreads have not yet hit a lower bound to where arbitrageurs/banks can act between bonds and the swap market to stabilize spreads. Luckily there are other relationships.
A brief note about mortgages backed by Fannie and Freddie (the vast majority in today’s environment) is that to the extent that the government or Federal reserve takes actions to “keep mortgage rates low”, ie at a low spread to government rates, these will behave like government securities in the arbitrage relationship outlined and will fail to influence swap spreads until spreads widen to a meaningful point to leverage mortgage securities to receive fixed from the mortgage market (after adjusting for all prepayment options) and pay fixed in the swap market. So an unintended consequence (see below for discussion on the general topic) of the Federal Reserve capping mortgage rates (as can be seen in the above graph from the St. Louis Fed Monetary Trends publication) is that it lowers the floor on swap spreads.
Bank Borrowers (Debtors) and Debtor - Bank Relationship:The graphs at the left taken from the St. Louis Federal Reserve Monetary Trends monthly publication give some insight into a potential cause of negative swap spreads: the decline of fixed rate borrowers. More so than from the government debt and mortgage markets, Banks source a material amount of fixed rate exposure from corporate, small business, and consumer loans. Given the recession and previous bubble in borrowings (evident left), borrowers are repaying loans and de-levering rapidly even as Banks (given swap spreads and signs of an improving economy) are getting more eager to lend as can be seen left with loosening lending standards. So we have a real sign that a critical supply of fixed payers is drying up. Normally a bank will lend at fixed + a credit spread (and recently given the crisis that credit spread has been very high) and then swap out to floating in the swaps market to receive floating which they then pay
to depositors to receive money to lend. With the decline of borrowers, it’s possible that banks are having to lend to the government in the bond market at a less attractive rate pressuring swap spreads as the banks try to maintain a profit margin.
A quick note on personal and state balance sheet repair through federal deficits which I have previously commented on. If this analysis holds, an unintended consequence of transferring private debts to the federal balance sheet is lowering (or negative) swap spreads. This is not necessarily a view on government credit quality as much as it is a result of reducing profitability of a key market intermediary- the Bank.
Bank Lenders (Bank Bond Buyers) and Lender - Bank Relationship:Banks have a outlet to pay fixed if they find themselves get long receiving fixed rates. They can issue bonds to the market which pay fixed rates. Given the obvious stress in the swap spreads market as banks get asked to pay more and more fixed rates and receive floating, it seems that banks are actually short fixed rates and so are more interested in other forms of raising cash (namely equity or deposits).
Equity Holders (Stock Holders) and Equity - Bank Relationship:Banks can raise permanent capital in the equity market (without the obligation to pay fixed rates per se) but are held accountable on their return on equity. This relationship serves to enforce on the bank that it only makes economic decisions. This contributes to the negative swap rate by imposing a limit of arbitrage in the government debt - swap rate interaction outlined above.
Depositor (included Fed) and Depositor - Bank Relationship:Just as banks can shed fixed rate exposure by issuing bonds, they can shed floating rate exposure by attracting deposits.
It is here (looking at depositor actions) that we see more signs of distortions (again from the St. Louis Fed). As noted above, in the corporate swap market we have signs that Banks are increasingly making fixed payments (and receiving floating payments) and are having trouble raising loans to source these fixed payments and are also increasingly looking for leverage in the government bond market given swap spreads but face a limit of arbitrage on leverage.
Another unintended consequence of the steep yield curve (the first being CFO’s swapping to floating) is that money is flowing out of short term (floating rate) deposits because deposits just don’t pay well in the eyes of the depositor. We see some indication of this with Libor very recently ticking up slightly (as can be seen in the graph on the left).
But it is important to remember that it is the Fed that has the largest impact on short term rates (independent of the supply of depositors to the extent that the Fed replaces depositors through open market operations) and so the effect of an unreasonably low deposit rate (that drives depositors away to other higher yielding securities or longer durations and forces the federal reserve to take open market measures to maintain low rates) manifests itself as a steep yield curve (seen left) that makes it very attractive for CFO’s to swap from fixed to floating as discussed above.
Pensions (old age insurance) and other Insurers and Insurance - Bank Relationship:The enactment of the Pension Protection Act of 2006 had the effect of requiring companies to gradually bring their retirement plans to fully funded status and maintain them that way and consequently gives strong encouragement to immunize their pension liabilities by receiving fixed rates which correspond to fixed future pension obligations. Perhaps a more tenuous link (and one which I admittedly have little evidence to support save the life expectancy chart to the left from the CDC) is that increasing life spans create longer
term liabilities in the health insurance and other markets (including an additional effect on pension liabilities). Presumably the pension issue is the dominant factor in this sector and creates a natural bid to receive fixed rates as pensions look for methods to increase portfolio duration to match liabilities.
Hedge Funds and the Hedge Fund - Bank Relationship:Lastly in the chart at the top is the hedge fund - bank relationship. Hedge funds that buy investment grade corporate debt from companies generally finance the purchases through the banking sector. They have the option to hedge interest rate exposure by swapping in one form or another to floating. Given the combination of credit spreads (at roughly 200bps) and short term interest rates (at 25bps) for a hedge fund to achieve an adequate return on equity (assumed to be 12%) without taking any interest rate risk would require leverage of 6 times (200bps * 6 = 12%). This is probably not acceptable for risk management reasons. If however funds take interest rate exposure, buy buying longer dated bonds and financing the purchase in the short term market, it is possible to achieve such a return with less than 3 times leverage. As a result it is likely that hedge funds investing in investment grade debt are electing to not hedge or to under-hedge interest rate exposure again leading to an imbalance of fixed rate receivers in the market (and an imbalance of paying fixed rates in the banking sector).
Insights, Consequences, Conclusions, Considerations and Trade Ideas:Reviewing the above discussion, I first note that credit quality of the US has not come into consideration. It can be that there are speculative positions being taken that are increasing the distortion in the swap spread market, but in my opinion this is unlikely. A key difference between the US and the so-called PIIGS - Portugal, Ireland, Italy, Greece, and Spain - is that the PIIGS cannot print their own currency of indebtedness due to the European Monetary Union. I have not explained how that can lead to negative swap rates but suffice it to say that the inability to print money in ones currency of indebtedness leads to credit risk which interferes with the government debt swap rate arbitrage relationship discussed above. The US does not have this problem and so I do not think that it is credit fears that are pushing swap spreads negative. Instead I would would guess:* Corporate hedging is likely very strong in the direction of receiving fixed due to the large
cost savings with the steep yield curve and the likely alignment with general corporate strategy to make costs variable with the recovery (spend more if the economy recovers).
* Government Bond Interest Rates are not yet high enough or the 10 Year Swap spread is not yet negative enough for the arbitrage relationship to work between these markets.
* An unintended consequence of the steep yield curve and the drive to keep mortgage rates lows is negative swap spreads.
* A reduction of general borrowings is removing an important supply of fixed rate payers which in turn leads to lower swap rates and negative swap spreads.
* An unintended consequence of taking private debts onto the public balance sheet (ie manufacturing savings) is negative swap spreads.
* Banks are at or below their lower range of desired profitability. Cost structures may be higher than historically.
* Banks are constrained by leverage and having difficulty raising deposits.* Pension funds are increasing the duration of their portfolios, competing to receive fixed.* Hedge funds are not hedging their interest rate exposure.This leads to a few themes:* The market is increasingly getting long fixed rates- that is the market is electing to receive
fixed driven largely by the slope of the yield curve.* The factors outlined above do not appear likely to change anytime soon, and therefore swap
rates are likely headed lower along with swap spreads.* There will be building pressure to flatten the yield curve as capital flows in search of higher
returns.Finally trade ideas:* Swap spreads are still not an attractive bet at this point. Risk is to even lower swap spread
especially while deflationary pressures continue.* Along these lines, due to short term deflationary pressures, receiving fixed rates is likely
going to become a crowded trade. Look for ways to take the other side....* The key to when to take a position I think is to watch loans. If lending start to pick up, swap
rates will likely rise (as will inflation). Given the crowded trade, swap rates have a potential to move sharply higher.
* An environment of rising swap rates has the potential to be positive for financial stocks as it signals a rising profitability in the business model.
* Avoid low return highly levered trades.* Long term call options on lowly levered companies could perform well as interest rates and
volatility increases. In general I like this trade even today with volatility declining as losses due to volatility drops are generally more than made up with rising equity prices.
A Brief Additional Note on Unintended Consequences and Functional Analysis:Occasionally in Bob Merton’s class at Harvard Business School I would catch hints of reference to his father, Robert King Merton, a brilliant sociologist who coined phases like self-fulfilling prophecy (which his son would reference in discussions of the rationality of bank runs) and unintended consequences. Robert K. Merton was a functionalist and presumably looked at the result of a particular structure to understand what function it was providing and thus understand its structure in a system. Thus the result was the input and the structure was the output - a demand driven analysis, which is not always the most intuitive starting point. Robert C. Merton, his son, later went to apply this same framework to understanding the financial system. Essentially bank are the way they are because that’s the structure needed in a particular society required to fulfill the needs that banks fulfill.
Arthur O’Keefe
The above graph is my structural analysis of the swap market in an attempt to understand what is driving swap spreads increasingly lower such that they are now negative at the 10 year point (they have been negative at the 30 year point for a while now). Said another way, the above is my analysis of fixed and floating rate payers and receivers in the cash and derivatives markets which I will explain below.
First a look at 10 year swap spreads (now negative) in the following graph:
The recent decline below 0 (now - 9bps as can be seen at the far right of the graph) is getting a lot of press recently. For instance here is a Bloomberg article which blames the phenomenon on corporate hedging. Later Bloomberg changed its story to say that the negative swap spreads were due to a glut in Treasury securities, and this seems to have caught on a wider following.
Personally my first reaction was that there must be some structural stress going on with the market, but that does not necessarily mean that the stress is due to a view of government credit quality relative to corporate credit quality. The graph at the left, though, shows swap spreads around the world, and one can certainly see that there is a strong correlation between negative swap spreads and countries having deficit problems. Correlation, though, does not equate to causality. Also what might be causing negative swap spreads in one market does
not necessarily cause them in another.
To really dig to the bottom of this, I looked at the swap system using a framework developed by one of my professor’s at Harvard Business School, Robert C. Merton (not to be confused with Robert K. Merton, his father and acclaimed sociologist whom I will discuss as well at the end of this entry). Bob (Robert C.) Merton is best known for winning the Nobel Prize in Economics for his insight of using Ito calculus to price options (ie developing the continuos time implementation of the Black-Scholes option pricing formula) and later for participating in the rise and fall of Long Term Capital Management. So since Merton already has a Nobel and a bit of fame/notoriety, his more recent work on things like pensions (with Zvi Bodie) and structures of financial systems has not garnered much attention. In some ways, though, his more recent work is even more impactful, in my opinion, than the closed form options pricing equation (Black-Scholes) which is widely used but nevertheless confined to the universe of options and derivatives traders. In any case, Merton with Bodie (link here:) postulates that the outputs of a financial system are dependent on financial institutions and intermediaries that evolve with the politics, customs, and behaviors of a society and so apparent distortions in the financial market would therefore be partly due to a structural deficiency or friction within the institutions.
So it can be that government deficits do indeed lead to negative swap spreads, but it is not at all clear why that should be the case and how it actually happens. Where exactly is the stress of government deficits showing up and who is really bearing the risk? Is it in the banks again as zero hedge postulates? Or is it somewhere else?
Hence the graph at the top of this post dissecting the sources of fixed and floating rate exposures in the market. Along the lines of Merton’s framework, the bank is seen as an intermediary in the whole process and acts only to transmit risk between entities, though it does introduce a friction in the form of a spread that it charges for its risk transmission service. So let’s translate this intricate graph:
Corporation Block and Corporation - Bank Relationship:Starting at the bank/corporate relationship (since that was where Bloomberg originally postulated the problem started and where the stress was most evident) we see that corporations issue bonds (mostly) to hedge funds and insurers paying a fixed rate - assume for 10 years to keep with the analysis of swap spreads. Bloomberg argued that corporations then enter into a swap arrangement with Banks to receive fixed and pay floating rates for the term of the bond issuance (10 years in this case).
Before analyzing how or why a Bank would do this, let’s think like a corporate treasurer/CFO in today’s interest rate environment. Specifically let’s think like the CFO of a generic BBB corporation today. The iBoxx Domestic Corporate BBB Spread to Libor index shown to the left shows a BBB credit spread of 1.92%. This is the credit spread to swap rates that a corporation of BBB credit quality pays and is generally in line with what one sees in the market today. 10 year swap rates (also shown on the left) shows that banks borrow for 10 years at 3.71% (the 10 year Libor or Swap rate) so the cost of borrowing to the treasurer is 1.92%+3.71% = 5.63%.
So if the CFO issues a bond and does nothing else, he has locked up 10 year financing at 5.63%. But is there anything else the CFO can do to lower borrowing costs today that might also strategically fit in with the companies revenue forecasts? Yes, the CFO can swap from fixed to floating by agreeing to pay 3 month Libor resetting every 3 months for the next 10 years and in return receive the 10 year Swap rate. 3 month libor is today .28% annualized (as can be seen in the chart at the left), so if the CFO does this, borrowing costs then become 5.63% - 3.71% + .28% = 2.2%. This is a 60% reduction in costs. And what risk is being taken for this reduction? Mainly the risk that short term rates increase. But under what circumstances will short term rates increase? Probably only a recovery, and in a recovery revenues will rise before and faster than interest rates (given the large amount of excess capacity in the system, the recovery will be well underway before rates rise), so from a business perspective, this is manageable. In the meantime if the recovery is
delayed, the company continues to pay 60% less in interest than it would under a 10 year fixed arrangement. So really, the decision is a “no brainer” for the CFO. Swap to floating.
Notice in this entire analysis, the CFO does not care where 10 year government rates are trading. Actually as can be seen in the chart on the left, investing in a 10 year government bonds will pay 3.83%, whereas the bank will only pay 3.71% as noted above, so the CFO will receive 10bps less than investing in government bonds, but the CFO still does the deal because the CFO is not looking to invest money - rather merely switch from a fixed rate to floating. Said
another way, the CFO is not concerned that the fixed rate the company will receive is less that the rate that the company would receive if the company because the CFO is not looking to deploy cash but is rather looking at 2 borrowing options, and in this case the CFO is making the more rational decision and swaps. The CFO’s actions will then push the swap market lower, but nevertheless the swap market will remain attractive for the next CFO who will do the same trade. So absent some other relationship (probably an arbitrage relationship as discussed below) with other actors the swap spread will continue lower until it reaches the point of indifference between swapping from fixed to floating for the marginal corporate borrower. But, there are other relationships as we continue around the diagram at the top of the page.
Government Debt (including mortgages) Block and Government Debt - Bank Relationship:So continuing right in the graph at the top (using Merton’s framework of analyzing a bank as an intermediary as opposed to a risk taking entity) we look at the Bank’s actions in the government debt market and how these might affect swap rates. There are two items which are critical. First is that the government debt market provides a source of fixed rate exposure and second is that there is spread differential (normally positive but now negative) between swap rates and the rate in the government debt market. Thus, in theory there is a arbitrage relationship between swaps and rates that prevents swap spreads from getting too negative (with the negative value representing frictions in the banking sector). That relationship is that at a certain point it becomes very profitable for a bank to buy government debt, receive fixed, pay fixed at a higher spread, receive floating, and pay floating to receive cash to buy government debt. So linking back to the CFO above, the CFO does not need to take a view on rates but rather can rely on this arbitrage relationship to ensure that the swap rate the company receiving is not too low. There are, however, limits of arbitrage. Here the limit is the amount of leverage that a bank can employ to buy government securities (a cash obligation) to pay fixed and receive floating in a swap transaction (a cashless transaction) relative to other investment opportunities to provide a return on the same amount of equity posted to borrow to buy the government bonds. As shown above to get a 15% return on equity with a -9bps swap spread would require leverage of 15/.09 = 167x. For a 5% ROE the leverage required would be 55x. Even at the very low range of acceptable return on equity we see that the amount of leverage required is a bit extraordinary (in today’s environment), therefore it is probably safe to say that swap spreads have not yet hit a lower bound to where arbitrageurs/banks can act between bonds and the swap market to stabilize spreads. Luckily there are other relationships.
A brief note about mortgages backed by Fannie and Freddie (the vast majority in today’s environment) is that to the extent that the government or Federal reserve takes actions to “keep mortgage rates low”, ie at a low spread to government rates, these will behave like government securities in the arbitrage relationship outlined and will fail to influence swap spreads until spreads widen to a meaningful point to leverage mortgage securities to receive fixed from the mortgage market (after adjusting for all prepayment options) and pay fixed in the swap market. So an unintended consequence (see below for discussion on the general topic) of the Federal Reserve capping mortgage rates (as can be seen in the above graph from the St. Louis Fed Monetary Trends publication) is that it lowers the floor on swap spreads.
Bank Borrowers (Debtors) and Debtor - Bank Relationship:The graphs at the left taken from the St. Louis Federal Reserve Monetary Trends monthly publication give some insight into a potential cause of negative swap spreads: the decline of fixed rate borrowers. More so than from the government debt and mortgage markets, Banks source a material amount of fixed rate exposure from corporate, small business, and consumer loans. Given the recession and previous bubble in borrowings (evident left), borrowers are repaying loans and de-levering rapidly even as Banks (given swap spreads and signs of an improving economy) are getting more eager to lend as can be seen left with loosening lending standards. So we have a real sign that a critical supply of fixed payers is drying up. Normally a bank will lend at fixed + a credit spread (and recently given the crisis that credit spread has been very high) and then swap out to floating in the swaps market to receive floating which they then pay
to depositors to receive money to lend. With the decline of borrowers, it’s possible that banks are having to lend to the government in the bond market at a less attractive rate pressuring swap spreads as the banks try to maintain a profit margin.
A quick note on personal and state balance sheet repair through federal deficits which I have previously commented on. If this analysis holds, an unintended consequence of transferring private debts to the federal balance sheet is lowering (or negative) swap spreads. This is not necessarily a view on government credit quality as much as it is a result of reducing profitability of a key market intermediary- the Bank.
Bank Lenders (Bank Bond Buyers) and Lender - Bank Relationship:Banks have a outlet to pay fixed if they find themselves get long receiving fixed rates. They can issue bonds to the market which pay fixed rates. Given the obvious stress in the swap spreads market as banks get asked to pay more and more fixed rates and receive floating, it seems that banks are actually short fixed rates and so are more interested in other forms of raising cash (namely equity or deposits).
Equity Holders (Stock Holders) and Equity - Bank Relationship:Banks can raise permanent capital in the equity market (without the obligation to pay fixed rates per se) but are held accountable on their return on equity. This relationship serves to enforce on the bank that it only makes economic decisions. This contributes to the negative swap rate by imposing a limit of arbitrage in the government debt - swap rate interaction outlined above.
Depositor (included Fed) and Depositor - Bank Relationship:Just as banks can shed fixed rate exposure by issuing bonds, they can shed floating rate exposure by attracting deposits.
It is here (looking at depositor actions) that we see more signs of distortions (again from the St. Louis Fed). As noted above, in the corporate swap market we have signs that Banks are increasingly making fixed payments (and receiving floating payments) and are having trouble raising loans to source these fixed payments and are also increasingly looking for leverage in the government bond market given swap spreads but face a limit of arbitrage on leverage.
Another unintended consequence of the steep yield curve (the first being CFO’s swapping to floating) is that money is flowing out of short term (floating rate) deposits because deposits just don’t pay well in the eyes of the depositor. We see some indication of this with Libor very recently ticking up slightly (as can be seen in the graph on the left).
But it is important to remember that it is the Fed that has the largest impact on short term rates (independent of the supply of depositors to the extent that the Fed replaces depositors through open market operations) and so the effect of an unreasonably low deposit rate (that drives depositors away to other higher yielding securities or longer durations and forces the federal reserve to take open market measures to maintain low rates) manifests itself as a steep yield curve (seen left) that makes it very attractive for CFO’s to swap from fixed to floating as discussed above.
Pensions (old age insurance) and other Insurers and Insurance - Bank Relationship:The enactment of the Pension Protection Act of 2006 had the effect of requiring companies to gradually bring their retirement plans to fully funded status and maintain them that way and consequently gives strong encouragement to immunize their pension liabilities by receiving fixed rates which correspond to fixed future pension obligations. Perhaps a more tenuous link (and one which I admittedly have little evidence to support save the life expectancy chart to the left from the CDC) is that increasing life spans create longer
term liabilities in the health insurance and other markets (including an additional effect on pension liabilities). Presumably the pension issue is the dominant factor in this sector and creates a natural bid to receive fixed rates as pensions look for methods to increase portfolio duration to match liabilities.
Hedge Funds and the Hedge Fund - Bank Relationship:Lastly in the chart at the top is the hedge fund - bank relationship. Hedge funds that buy investment grade corporate debt from companies generally finance the purchases through the banking sector. They have the option to hedge interest rate exposure by swapping in one form or another to floating. Given the combination of credit spreads (at roughly 200bps) and short term interest rates (at 25bps) for a hedge fund to achieve an adequate return on equity (assumed to be 12%) without taking any interest rate risk would require leverage of 6 times (200bps * 6 = 12%). This is probably not acceptable for risk management reasons. If however funds take interest rate exposure, buy buying longer dated bonds and financing the purchase in the short term market, it is possible to achieve such a return with less than 3 times leverage. As a result it is likely that hedge funds investing in investment grade debt are electing to not hedge or to under-hedge interest rate exposure again leading to an imbalance of fixed rate receivers in the market (and an imbalance of paying fixed rates in the banking sector).
Insights, Consequences, Conclusions, Considerations and Trade Ideas:Reviewing the above discussion, I first note that credit quality of the US has not come into consideration. It can be that there are speculative positions being taken that are increasing the distortion in the swap spread market, but in my opinion this is unlikely. A key difference between the US and the so-called PIIGS - Portugal, Ireland, Italy, Greece, and Spain - is that the PIIGS cannot print their own currency of indebtedness due to the European Monetary Union. I have not explained how that can lead to negative swap rates but suffice it to say that the inability to print money in ones currency of indebtedness leads to credit risk which interferes with the government debt swap rate arbitrage relationship discussed above. The US does not have this problem and so I do not think that it is credit fears that are pushing swap spreads negative. Instead I would would guess:* Corporate hedging is likely very strong in the direction of receiving fixed due to the large
cost savings with the steep yield curve and the likely alignment with general corporate strategy to make costs variable with the recovery (spend more if the economy recovers).
* Government Bond Interest Rates are not yet high enough or the 10 Year Swap spread is not yet negative enough for the arbitrage relationship to work between these markets.
* An unintended consequence of the steep yield curve and the drive to keep mortgage rates lows is negative swap spreads.
* A reduction of general borrowings is removing an important supply of fixed rate payers which in turn leads to lower swap rates and negative swap spreads.
* An unintended consequence of taking private debts onto the public balance sheet (ie manufacturing savings) is negative swap spreads.
* Banks are at or below their lower range of desired profitability. Cost structures may be higher than historically.
* Banks are constrained by leverage and having difficulty raising deposits.* Pension funds are increasing the duration of their portfolios, competing to receive fixed.* Hedge funds are not hedging their interest rate exposure.This leads to a few themes:* The market is increasingly getting long fixed rates- that is the market is electing to receive
fixed driven largely by the slope of the yield curve.* The factors outlined above do not appear likely to change anytime soon, and therefore swap
rates are likely headed lower along with swap spreads.* There will be building pressure to flatten the yield curve as capital flows in search of higher
returns.Finally trade ideas:* Swap spreads are still not an attractive bet at this point. Risk is to even lower swap spread
especially while deflationary pressures continue.* Along these lines, due to short term deflationary pressures, receiving fixed rates is likely
going to become a crowded trade. Look for ways to take the other side....* The key to when to take a position I think is to watch loans. If lending start to pick up, swap
rates will likely rise (as will inflation). Given the crowded trade, swap rates have a potential to move sharply higher.
* An environment of rising swap rates has the potential to be positive for financial stocks as it signals a rising profitability in the business model.
* Avoid low return highly levered trades.* Long term call options on lowly levered companies could perform well as interest rates and
volatility increases. In general I like this trade even today with volatility declining as losses due to volatility drops are generally more than made up with rising equity prices.
A Brief Additional Note on Unintended Consequences and Functional Analysis:Occasionally in Bob Merton’s class at Harvard Business School I would catch hints of reference to his father, Robert King Merton, a brilliant sociologist who coined phases like self-fulfilling prophecy (which his son would reference in discussions of the rationality of bank runs) and unintended consequences. Robert K. Merton was a functionalist and presumably looked at the result of a particular structure to understand what function it was providing and thus understand its structure in a system. Thus the result was the input and the structure was the output - a demand driven analysis, which is not always the most intuitive starting point. Robert C. Merton, his son, later went to apply this same framework to understanding the financial system. Essentially bank are the way they are because that’s the structure needed in a particular society required to fulfill the needs that banks fulfill.
Arthur O’Keefe
The above graph is my structural analysis of the swap market in an attempt to understand what is driving swap spreads increasingly lower such that they are now negative at the 10 year point (they have been negative at the 30 year point for a while now). Said another way, the above is my analysis of fixed and floating rate payers and receivers in the cash and derivatives markets which I will explain below.
First a look at 10 year swap spreads (now negative) in the following graph:
The recent decline below 0 (now - 9bps as can be seen at the far right of the graph) is getting a lot of press recently. For instance here is a Bloomberg article which blames the phenomenon on corporate hedging. Later Bloomberg changed its story to say that the negative swap spreads were due to a glut in Treasury securities, and this seems to have caught on a wider following.
Personally my first reaction was that there must be some structural stress going on with the market, but that does not necessarily mean that the stress is due to a view of government credit quality relative to corporate credit quality. The graph at the left, though, shows swap spreads around the world, and one can certainly see that there is a strong correlation between negative swap spreads and countries having deficit problems. Correlation, though, does not equate to causality. Also what might be causing negative swap spreads in one market does
not necessarily cause them in another.
To really dig to the bottom of this, I looked at the swap system using a framework developed by one of my professor’s at Harvard Business School, Robert C. Merton (not to be confused with Robert K. Merton, his father and acclaimed sociologist whom I will discuss as well at the end of this entry). Bob (Robert C.) Merton is best known for winning the Nobel Prize in Economics for his insight of using Ito calculus to price options (ie developing the continuos time implementation of the Black-Scholes option pricing formula) and later for participating in the rise and fall of Long Term Capital Management. So since Merton already has a Nobel and a bit of fame/notoriety, his more recent work on things like pensions (with Zvi Bodie) and structures of financial systems has not garnered much attention. In some ways, though, his more recent work is even more impactful, in my opinion, than the closed form options pricing equation (Black-Scholes) which is widely used but nevertheless confined to the universe of options and derivatives traders. In any case, Merton with Bodie (link here:) postulates that the outputs of a financial system are dependent on financial institutions and intermediaries that evolve with the politics, customs, and behaviors of a society and so apparent distortions in the financial market would therefore be partly due to a structural deficiency or friction within the institutions.
So it can be that government deficits do indeed lead to negative swap spreads, but it is not at all clear why that should be the case and how it actually happens. Where exactly is the stress of government deficits showing up and who is really bearing the risk? Is it in the banks again as zero hedge postulates? Or is it somewhere else?
Hence the graph at the top of this post dissecting the sources of fixed and floating rate exposures in the market. Along the lines of Merton’s framework, the bank is seen as an intermediary in the whole process and acts only to transmit risk between entities, though it does introduce a friction in the form of a spread that it charges for its risk transmission service. So let’s translate this intricate graph:
Corporation Block and Corporation - Bank Relationship:Starting at the bank/corporate relationship (since that was where Bloomberg originally postulated the problem started and where the stress was most evident) we see that corporations issue bonds (mostly) to hedge funds and insurers paying a fixed rate - assume for 10 years to keep with the analysis of swap spreads. Bloomberg argued that corporations then enter into a swap arrangement with Banks to receive fixed and pay floating rates for the term of the bond issuance (10 years in this case).
Before analyzing how or why a Bank would do this, let’s think like a corporate treasurer/CFO in today’s interest rate environment. Specifically let’s think like the CFO of a generic BBB corporation today. The iBoxx Domestic Corporate BBB Spread to Libor index shown to the left shows a BBB credit spread of 1.92%. This is the credit spread to swap rates that a corporation of BBB credit quality pays and is generally in line with what one sees in the market today. 10 year swap rates (also shown on the left) shows that banks borrow for 10 years at 3.71% (the 10 year Libor or Swap rate) so the cost of borrowing to the treasurer is 1.92%+3.71% = 5.63%.
So if the CFO issues a bond and does nothing else, he has locked up 10 year financing at 5.63%. But is there anything else the CFO can do to lower borrowing costs today that might also strategically fit in with the companies revenue forecasts? Yes, the CFO can swap from fixed to floating by agreeing to pay 3 month Libor resetting every 3 months for the next 10 years and in return receive the 10 year Swap rate. 3 month libor is today .28% annualized (as can be seen in the chart at the left), so if the CFO does this, borrowing costs then become 5.63% - 3.71% + .28% = 2.2%. This is a 60% reduction in costs. And what risk is being taken for this reduction? Mainly the risk that short term rates increase. But under what circumstances will short term rates increase? Probably only a recovery, and in a recovery revenues will rise before and faster than interest rates (given the large amount of excess capacity in the system, the recovery will be well underway before rates rise), so from a business perspective, this is manageable. In the meantime if the recovery is
delayed, the company continues to pay 60% less in interest than it would under a 10 year fixed arrangement. So really, the decision is a “no brainer” for the CFO. Swap to floating.
Notice in this entire analysis, the CFO does not care where 10 year government rates are trading. Actually as can be seen in the chart on the left, investing in a 10 year government bonds will pay 3.83%, whereas the bank will only pay 3.71% as noted above, so the CFO will receive 10bps less than investing in government bonds, but the CFO still does the deal because the CFO is not looking to invest money - rather merely switch from a fixed rate to floating. Said
another way, the CFO is not concerned that the fixed rate the company will receive is less that the rate that the company would receive if the company because the CFO is not looking to deploy cash but is rather looking at 2 borrowing options, and in this case the CFO is making the more rational decision and swaps. The CFO’s actions will then push the swap market lower, but nevertheless the swap market will remain attractive for the next CFO who will do the same trade. So absent some other relationship (probably an arbitrage relationship as discussed below) with other actors the swap spread will continue lower until it reaches the point of indifference between swapping from fixed to floating for the marginal corporate borrower. But, there are other relationships as we continue around the diagram at the top of the page.
Government Debt (including mortgages) Block and Government Debt - Bank Relationship:So continuing right in the graph at the top (using Merton’s framework of analyzing a bank as an intermediary as opposed to a risk taking entity) we look at the Bank’s actions in the government debt market and how these might affect swap rates. There are two items which are critical. First is that the government debt market provides a source of fixed rate exposure and second is that there is spread differential (normally positive but now negative) between swap rates and the rate in the government debt market. Thus, in theory there is a arbitrage relationship between swaps and rates that prevents swap spreads from getting too negative (with the negative value representing frictions in the banking sector). That relationship is that at a certain point it becomes very profitable for a bank to buy government debt, receive fixed, pay fixed at a higher spread, receive floating, and pay floating to receive cash to buy government debt. So linking back to the CFO above, the CFO does not need to take a view on rates but rather can rely on this arbitrage relationship to ensure that the swap rate the company receiving is not too low. There are, however, limits of arbitrage. Here the limit is the amount of leverage that a bank can employ to buy government securities (a cash obligation) to pay fixed and receive floating in a swap transaction (a cashless transaction) relative to other investment opportunities to provide a return on the same amount of equity posted to borrow to buy the government bonds. As shown above to get a 15% return on equity with a -9bps swap spread would require leverage of 15/.09 = 167x. For a 5% ROE the leverage required would be 55x. Even at the very low range of acceptable return on equity we see that the amount of leverage required is a bit extraordinary (in today’s environment), therefore it is probably safe to say that swap spreads have not yet hit a lower bound to where arbitrageurs/banks can act between bonds and the swap market to stabilize spreads. Luckily there are other relationships.
A brief note about mortgages backed by Fannie and Freddie (the vast majority in today’s environment) is that to the extent that the government or Federal reserve takes actions to “keep mortgage rates low”, ie at a low spread to government rates, these will behave like government securities in the arbitrage relationship outlined and will fail to influence swap spreads until spreads widen to a meaningful point to leverage mortgage securities to receive fixed from the mortgage market (after adjusting for all prepayment options) and pay fixed in the swap market. So an unintended consequence (see below for discussion on the general topic) of the Federal Reserve capping mortgage rates (as can be seen in the above graph from the St. Louis Fed Monetary Trends publication) is that it lowers the floor on swap spreads.
Bank Borrowers (Debtors) and Debtor - Bank Relationship:The graphs at the left taken from the St. Louis Federal Reserve Monetary Trends monthly publication give some insight into a potential cause of negative swap spreads: the decline of fixed rate borrowers. More so than from the government debt and mortgage markets, Banks source a material amount of fixed rate exposure from corporate, small business, and consumer loans. Given the recession and previous bubble in borrowings (evident left), borrowers are repaying loans and de-levering rapidly even as Banks (given swap spreads and signs of an improving economy) are getting more eager to lend as can be seen left with loosening lending standards. So we have a real sign that a critical supply of fixed payers is drying up. Normally a bank will lend at fixed + a credit spread (and recently given the crisis that credit spread has been very high) and then swap out to floating in the swaps market to receive floating which they then pay
to depositors to receive money to lend. With the decline of borrowers, it’s possible that banks are having to lend to the government in the bond market at a less attractive rate pressuring swap spreads as the banks try to maintain a profit margin.
A quick note on personal and state balance sheet repair through federal deficits which I have previously commented on. If this analysis holds, an unintended consequence of transferring private debts to the federal balance sheet is lowering (or negative) swap spreads. This is not necessarily a view on government credit quality as much as it is a result of reducing profitability of a key market intermediary- the Bank.
Bank Lenders (Bank Bond Buyers) and Lender - Bank Relationship:Banks have a outlet to pay fixed if they find themselves get long receiving fixed rates. They can issue bonds to the market which pay fixed rates. Given the obvious stress in the swap spreads market as banks get asked to pay more and more fixed rates and receive floating, it seems that banks are actually short fixed rates and so are more interested in other forms of raising cash (namely equity or deposits).
Equity Holders (Stock Holders) and Equity - Bank Relationship:Banks can raise permanent capital in the equity market (without the obligation to pay fixed rates per se) but are held accountable on their return on equity. This relationship serves to enforce on the bank that it only makes economic decisions. This contributes to the negative swap rate by imposing a limit of arbitrage in the government debt - swap rate interaction outlined above.
Depositor (included Fed) and Depositor - Bank Relationship:Just as banks can shed fixed rate exposure by issuing bonds, they can shed floating rate exposure by attracting deposits.
It is here (looking at depositor actions) that we see more signs of distortions (again from the St. Louis Fed). As noted above, in the corporate swap market we have signs that Banks are increasingly making fixed payments (and receiving floating payments) and are having trouble raising loans to source these fixed payments and are also increasingly looking for leverage in the government bond market given swap spreads but face a limit of arbitrage on leverage.
Another unintended consequence of the steep yield curve (the first being CFO’s swapping to floating) is that money is flowing out of short term (floating rate) deposits because deposits just don’t pay well in the eyes of the depositor. We see some indication of this with Libor very recently ticking up slightly (as can be seen in the graph on the left).
But it is important to remember that it is the Fed that has the largest impact on short term rates (independent of the supply of depositors to the extent that the Fed replaces depositors through open market operations) and so the effect of an unreasonably low deposit rate (that drives depositors away to other higher yielding securities or longer durations and forces the federal reserve to take open market measures to maintain low rates) manifests itself as a steep yield curve (seen left) that makes it very attractive for CFO’s to swap from fixed to floating as discussed above.
Pensions (old age insurance) and other Insurers and Insurance - Bank Relationship:The enactment of the Pension Protection Act of 2006 had the effect of requiring companies to gradually bring their retirement plans to fully funded status and maintain them that way and consequently gives strong encouragement to immunize their pension liabilities by receiving fixed rates which correspond to fixed future pension obligations. Perhaps a more tenuous link (and one which I admittedly have little evidence to support save the life expectancy chart to the left from the CDC) is that increasing life spans create longer
term liabilities in the health insurance and other markets (including an additional effect on pension liabilities). Presumably the pension issue is the dominant factor in this sector and creates a natural bid to receive fixed rates as pensions look for methods to increase portfolio duration to match liabilities.
Hedge Funds and the Hedge Fund - Bank Relationship:Lastly in the chart at the top is the hedge fund - bank relationship. Hedge funds that buy investment grade corporate debt from companies generally finance the purchases through the banking sector. They have the option to hedge interest rate exposure by swapping in one form or another to floating. Given the combination of credit spreads (at roughly 200bps) and short term interest rates (at 25bps) for a hedge fund to achieve an adequate return on equity (assumed to be 12%) without taking any interest rate risk would require leverage of 6 times (200bps * 6 = 12%). This is probably not acceptable for risk management reasons. If however funds take interest rate exposure, buy buying longer dated bonds and financing the purchase in the short term market, it is possible to achieve such a return with less than 3 times leverage. As a result it is likely that hedge funds investing in investment grade debt are electing to not hedge or to under-hedge interest rate exposure again leading to an imbalance of fixed rate receivers in the market (and an imbalance of paying fixed rates in the banking sector).
Insights, Consequences, Conclusions, Considerations and Trade Ideas:Reviewing the above discussion, I first note that credit quality of the US has not come into consideration. It can be that there are speculative positions being taken that are increasing the distortion in the swap spread market, but in my opinion this is unlikely. A key difference between the US and the so-called PIIGS - Portugal, Ireland, Italy, Greece, and Spain - is that the PIIGS cannot print their own currency of indebtedness due to the European Monetary Union. I have not explained how that can lead to negative swap rates but suffice it to say that the inability to print money in ones currency of indebtedness leads to credit risk which interferes with the government debt swap rate arbitrage relationship discussed above. The US does not have this problem and so I do not think that it is credit fears that are pushing swap spreads negative. Instead I would would guess:* Corporate hedging is likely very strong in the direction of receiving fixed due to the large
cost savings with the steep yield curve and the likely alignment with general corporate strategy to make costs variable with the recovery (spend more if the economy recovers).
* Government Bond Interest Rates are not yet high enough or the 10 Year Swap spread is not yet negative enough for the arbitrage relationship to work between these markets.
* An unintended consequence of the steep yield curve and the drive to keep mortgage rates lows is negative swap spreads.
* A reduction of general borrowings is removing an important supply of fixed rate payers which in turn leads to lower swap rates and negative swap spreads.
* An unintended consequence of taking private debts onto the public balance sheet (ie manufacturing savings) is negative swap spreads.
* Banks are at or below their lower range of desired profitability. Cost structures may be higher than historically.
* Banks are constrained by leverage and having difficulty raising deposits.* Pension funds are increasing the duration of their portfolios, competing to receive fixed.* Hedge funds are not hedging their interest rate exposure.This leads to a few themes:* The market is increasingly getting long fixed rates- that is the market is electing to receive
fixed driven largely by the slope of the yield curve.* The factors outlined above do not appear likely to change anytime soon, and therefore swap
rates are likely headed lower along with swap spreads.* There will be building pressure to flatten the yield curve as capital flows in search of higher
returns.Finally trade ideas:* Swap spreads are still not an attractive bet at this point. Risk is to even lower swap spread
especially while deflationary pressures continue.* Along these lines, due to short term deflationary pressures, receiving fixed rates is likely
going to become a crowded trade. Look for ways to take the other side....* The key to when to take a position I think is to watch loans. If lending start to pick up, swap
rates will likely rise (as will inflation). Given the crowded trade, swap rates have a potential to move sharply higher.
* An environment of rising swap rates has the potential to be positive for financial stocks as it signals a rising profitability in the business model.
* Avoid low return highly levered trades.* Long term call options on lowly levered companies could perform well as interest rates and
volatility increases. In general I like this trade even today with volatility declining as losses due to volatility drops are generally more than made up with rising equity prices.
A Brief Additional Note on Unintended Consequences and Functional Analysis:Occasionally in Bob Merton’s class at Harvard Business School I would catch hints of reference to his father, Robert King Merton, a brilliant sociologist who coined phases like self-fulfilling prophecy (which his son would reference in discussions of the rationality of bank runs) and unintended consequences. Robert K. Merton was a functionalist and presumably looked at the result of a particular structure to understand what function it was providing and thus understand its structure in a system. Thus the result was the input and the structure was the output - a demand driven analysis, which is not always the most intuitive starting point. Robert C. Merton, his son, later went to apply this same framework to understanding the financial system. Essentially bank are the way they are because that’s the structure needed in a particular society required to fulfill the needs that banks fulfill.
Arthur O’Keefe
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