Treasury Notes

 Examining Swap Spreads and the Implications for Funding the Government

By: James Clark and Gabriel Mann
6/9/2016

This blog post is the third in a series on fixed income market dynamics by the Department of the Treasury to share our perspective on the available data, discuss key structural and cyclical trends, and reiterate our policy priorities. This post examines swap spreads.

Since the financial crisis, the relationship between Treasury securities and interest rate swaps has changed.  Swap rates have tended to decline relative to Treasury yields, resulting in a negative swap spread for some tenors.  Some argue that this change means that there is a higher cost for funding the government relative to the corporate sector.  Below we explain why that argument is flawed by taking a closer look at relative funding costs and structural dynamics within the swaps market. 

For context, interest rate swaps are used for a variety of purposes.  For example, businesses use interest rate swaps to adjust existing liabilities from fixed rate obligations to floating rate payments which typically reference LIBOR (or vice versa), and investors trade swaps to speculate on the path of long-term interest rates relative to short-term interest rates.  By the end of 2015, a notional $96 trillion of dollar-based interest rate swaps were outstanding, according to the Bank for International Settlements.

As in most fixed income markets, when discussing whether a rate is high or low, the convention is to compare the rate to that of another fixed income security.  Interest rate swaps are typically compared to Treasury securities of comparable maturity in order to calculate the "swap spread."  Specifically, the swap spread equals the swap rate of the fixed leg minus the Treasury rate for comparable maturities.  For example, if the current market rate for a 5-year swap is 1.35 percent and the current yield on the 5-year Treasury note is 1.33 percent, the 5-year swap spread would be 2 basis points. 

Over the past two years, swap spreads have generally tightened, which is to say the difference between Treasury yields and swap rates has declined.  In late 2008, 30-year swap spreads turned negative.  More recently, 10-year swap spreads have been negative, while 5-year swap spreads turned negative last year but are currently close to zero.  Two-year swap spreads remain positive but briefly dropped below 5 basis points in March.

 

 
Source: Bloomberg

Some say that these trends are evidence that the Treasury's funding costs are now higher than private sector institutions.  But the decline in the spread between swap rates and Treasury rates does not indicate that the cost of funding for the U.S. government has risen compared to the borrowing rates paid by the private sector.  Treasury yields remain near historical lows, and private companies that seek financing continue to pay more than Treasury to issue debt of a given maturity.  The charts below explain this dynamic in more detail.

Corporate Spreads:  Standard interest rate swaps do not involve an exchange of principal at the outset or conclusion of the trade; accordingly, the rate on the fixed leg of an interest rate swap does not reflect the rate at which corporations borrow money.  Corporate entities, including banks, almost always pay a higher rate of interest to borrow than the U.S. government (i.e., there is a "positive spread").  The chart below shows that the spread between AAA-rated corporate securities and Treasury securities has remained both positive and relatively constant in recent years.  The positive spread indicates that the rate at which the most highly-rated corporations actually issue debt remains above the rate paid by the U.S. government, and shows that the relative funding advantage enjoyed by Treasury has not changed meaningfully since the crisis.



Source: Federal Reserve of St. Louis, BAML

3-Month Treasury Bills Versus 3-Month Commercial Paper: While the chart above reflects the relative cost of issuing longer-dated debt, many corporations also access funding in the capital markets by issuing short-term commercial paper (CP).  Below, we show that the spread between a highly-rated (specifically A1/P1/F1) 3-month CP index and 3-month Treasury bill yields has remained positive.  This means that the rate Treasury pays when issuing shorter-dated debt continues to be lower than that of highly-rated corporations.  Moreover, the relative costs have also generally remained constant over the last few years.


Source: Bloomberg

3-Month Treasury Bills Versus 3-Month Overnight Indexed Swap:   Another way to evaluate Treasury's funding costs is to compare short-term Treasury yields to the Overnight Indexed Swap (OIS), a near-risk-free and widely-used interest rate swap in which the floating leg is calculated using the Federal Funds Effective rate.  The chart below shows that the 3-month OIS rate typically has traded above the 3-month Treasury bill rate.

 
Source: Bloomberg

It is clear that Treasury continues to fund more cheaply than corporates and near risk-free benchmarks.  Of course, the changes in swap spreads over the past several years are important to monitor and analyze for what they may tell us about developments in financial markets and market functioning.  Our analysis to date suggests that a number of factors are likely affecting the level of swap spreads, several of which we highlight below. 

Structural Shifts in Demand for Swaps:  Over the past several years, market developments have altered supply and demand dynamics in the interest rate swaps market.  The GSEs' retained portfolio of mortgages, which is often hedged with net pay-fixed positions, has declined since 2008.  Over the same period, the Federal Reserve, which does not hedge its portfolio with interest rate swaps, has substantially increased its holdings of Agency Mortgage Backed Securities (MBS).  Separately, corporate issuance, which is often hedged by receiving the fixed leg of an interest rate swap, has increased to record levels.  All else being equal, structural declines in demand for net pay-fixed positions and increases in demand for net receive-fixed positions will help to move swap spreads lower.

 



Source: Fannie Mae, Freddie Mac

 

 

 
Source: SIFMA

Reserve Manager Selling of Treasury Securities:  A variety of macro factors led some foreign central banks to sell a portion of their U.S. dollar-denominated assets in the second half of last year.  This type of selling, highlighted by the dashed circle below, may have created upward pressure on Treasury rates relative to swaps rates.  The tightening of swap spreads we have seen since August 2015 is consistent with this dynamic. 


Source: Treasury

Relative Cost of Funding: Another driver of the recent move in swap spreads may be the relative cost of funding Treasury securities versus similar positions in interest rate swaps.  Below, we use the spread between 3-month LIBOR and the 3-month General Collateral term rate (GC) as a proxy for the price of financing a Treasury position against funding a swap position.  The chart below shows that this spread tracks closely with swap spreads, with the exception of unusual periods that likely coincided with Europe-related turbulence between 2010 and 2012.

The recent tightening in swap spreads initially coincided with an increase in the cost of funding Treasury securities versus swaps.  In fact, the 3-month LIBOR-GC spread went negative at the end of 2015.  However, since that time, the LIBOR-GC spread has reverted to historical levels while swap spreads have remained negative.  This dynamic suggests that there may be other factors contributing to the current level of swap spreads, much like previous periods when such a divergence existed.

 



Source: Bloomberg

Changes to Swaps Market Infrastructure: The shift toward central clearing for most interest rate swaps has also reduced the counterparty risk associated with those agreements, which lowers the price of the fixed leg of a swap, all else being equal.  While most interest rate swaps have been centrally cleared in the U.S. for the last few years, Europe will begin mandatory central clearing for most interest rate swaps later this year.  Watching how European swap spreads react to these changes will help to inform our analysis of the aggregate effect of changes to the swaps market structure.

In summary, our judgment is that the tightening of swap spreads does not reflect a deterioration in Treasury's funding costs.  Disentangling the various drivers behind the recent moves in swap spreads and understanding their separate effects is difficult.  But, as with all financial market developments, we will continue to monitor these factors and their potential implications for Treasury market liquidity and our overall funding costs.

James Clark is the Deputy Assistant Secretary for Federal Finance, and Gabriel Mann is a policy advisor in the Office of Debt Management at the U.S. Treasury Department.

Posted in:  Fixed Income
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