Interest Rate Research

24 May 2011

Whats Up With Swap Spreads?

The unusual period of negative NZ swap-bonds spreads appears to be coming to an end. We expect positive swap spreads to be sustained and increase. A more balanced supply to demand ratio for Government bonds should see long bond yields decline relative to swap yields. A tight Budget should also limit further risk premium being applied to long Government bond yields relative to swap yields. Some expected flattening in the yield curve, as interest rates rise should also be associated with a sustained positive swap spread. Positive swap spreads should see increased issuance in areas such as S.S.A1 Kauri bonds where swapreferenced yields will appear more attractive to investors, relative to NZ Government bond yields.
Global 10-year swap to bond spreads
1.5 1.2 0.9 0.6 0.3 0 -0.3 18/04/1996

18/04/1999

Source: Bloomberg

18/04/2002 18/04/2005 AU 10-year swap spread US 10-year swap spread Germany 10-year swap spread UK 10-year swap spread

18/04/2008

18/04/2011

Recently there have been some interesting developments in the relationship between NZ long bond and swap yields. In the last few weeks, swap-bond spreads have returned to positive territory after almost a year below zero. Generally swap yields trade above bonds of similar maturity. Over the past year or so, however, NZ swap yields have traded below bonds at the long end of the curve (5, 7 and 10 year). This has been an aberration in the 15 year history of NZ swap spreads and is also unusual on a global basis. A positive swap spread is the norm globally. Australian and German 10-year swap spreads have always been
(%) 1.5 1.3 1.1 0.9 0.7 0.5 0.3 0.1 -0.1 -0.3 -0.5 18/04/1996
Source: Bloomberg

positive. The UK and the US have experienced only very short-lived periods of negative 10-year swap spreads in the last couple of years. At the very long end of the curve (25-30 years), however, markets such as the US and UK have seen more prolonged periods of negative swap spreads. We will therefore attempt to answer four questions: (i) (ii) (iii) (iv) Why does the swap spread matter? What determines swap spreads over bonds? What caused NZ swaps to trade below bonds and what drove the normalisation? Where to with swap spreads from here?

(I) Why do swap spreads matter?

They matter to corporate, supranational and agency credit issuers and their investors. These entities issue credit with reference to swap rates. Investors compare the attractiveness of these investments, relative to Government bonds, which can have greater liquidity and should represent lower default risk. The swap-bond spread is therefore critical in determining the relative attractiveness of fixed interest investments. In addition, some fixed income funds are benchmarked to swaps making the swap spread critical to investment decisions. They matter to sovereign debt issuers making decisions around whether to shorten the duration of public debt through engaging in swaps. They matters to traders who hope to benefit from trading the spread, know as EFP (Exchange For Physical). i.e. A transaction in which one party buys the physical commodity (bond) and simultaneously sells the derivative (swap), and the other party does the opposite.

New Zealand 5 and 10 year swap-bond spreads

18/04/1999

18/04/2002

18/04/2005

18/04/2008

18/04/2011

NZ 5-year swap spread NZ 10-year swap spread

AAA rated Supranationals, Sovereigns and Agencies

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(II) What determines swap spread over bonds?

There is a swathe of financial literature as to why swaps theoretically trade above bonds and what determines the spread. Most of these concentrate on the US market, but recurring themes are; 1/ Government bond supply issues 2/ relative credit risk inherent in the two instruments 3/ the slope of the yield curve. 1/ Government bond supply relative to demand has the potential to shift bond yields. Bonds have a scarcity or abundance factor which swaps do not. All else equal, swap spreads should narrow when bond issuance increases. 2/ Relative credit risk. The risk of default for a bond lies with the credit-worthiness of the sovereign. Swaps contain an inherent risk of counterparty default. Ultimately the bank quoting the floating rate could default, although in recent years banks have put in place 2C.S.A. agreements that reduce much of the credit risk. 3/ The shape of the yield curve. When the curve is steep the demand to be a fixed rate receiver in a swap increases. Hence a steeper yield curve could be expected to be associated with tighter swap spreads. Therefore if these findings hold, the spread between swaps and bonds would be expected to narrow when bond supply increased, when perceived risk of Government default relative to banks increased, and when the yield curve steepened.

expanded its deficit during the recession. NZ 10-year bond yields moved below swap yields for the first time in March 2010. They moved more convincingly into negative territory in July 2010. Second, in addition to pure supply/demand dynamics the related issue is perceived Government default risk associated with a pick up in debt issuance. An increase in the overall bonds outstanding incrementally raises the risk of holding those bonds. Hence an increased risk premium is applied to the bond yield relative to the credit risk inherent in the swap yield. An exaggerated example of the phenomena is Ireland. From 1996 to early 2008 Irelands sovereign 10-year bonds showed a typical relationship, trading 20bp below swaps on average. More recently as Irelands Government debt issues have reached crisis point, 10-year bond yields have soared to around 10%, well above 10-year swap rates at 3.4%. Irish swap spreads are therefore massively negative. While NZ Govt debt levels are far from Irelands a marginal increase in perceived default risk has also been at play in the NZ market.
NZ 10-year swap spread vs yield curve
1.5
-1.5

-1

-0.5

(III) What caused NZ swap spreads to narrow to the point of being negative?
NZ Government bonds outstanding
NZD bn 45 40

0.5

0.5

1.5

-0.5 1/01/2000

2.5

1/01/2002

1/01/2004

1/01/2006

1/01/2008

1/01/2010

NZ 10-year swap spread

Source: Bloomberg

35 30 25 20 15 10 5 0 1/01/2000

10 year swap minus 2 year swap

1/01/2002

1/01/2004

1/01/2006

1/01/2008

1/01/2010

Source: RBNZ

NZ Government bonds outstanding

Third, the recent decline in 10-year swap spreads into negative territory has coincided with the steepening in the yield curve to the steepest in history. As the OCR has been slashed to the historically low level of 2.5% the curve has steepened dramatically. Steeping in the yield curve has also been associated with the cyclical dips of NZ GDP growth (qoq) into negative territory, and troughs in investor sentiment post the Christchurch earthquakes. Expressing the view that the RBNZ will cut rates/stay lower for longer can be done effectively through swaps without the upfront cost of purchasing bonds. Swaps are therefore a more leveraged way (with greater liquidity in the context of the NZ market) of expressing negative economic sentiment. Participants are motivated to receive high fixed rates while paying low current floating rates through swaps. Hence swap yields fell further and more rapidly than bond yields.

First, the period of negative swap spreads has coincided with the meaningful pick-up in net debt issuance by the NZ Government. Total Government bonds outstanding began a steep ascent from the start of 2010, having been fairly stable over the previous decade. Bonds outstanding have almost doubled since late 2009, as the Government
2

Credit Support Annex

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NZ GDP
3 2.5 2 1.5 1 0.5 0 -0.5 -1 -1.5 30/06/1996

(IV) Where to with swap spreads from here?

We turn to the three recent drivers of the swap spread. First, the spike in recent weeks in the bid-to-cover ratio for NZ bonds is unlikely to be sustained. (indeed in last weeks auction much lower levels were achieved). However, the Government has recently built up cash balances through pre-funding. In the 2011/12 Budget it has also announced a gradual reduction in gross bond issuance over the next few years from 13.5bn in 2011/12 to 8bn in 2014/15. This will mean net bond issuance of just 5.9bn in the coming fiscal year. We therefore believe demand relative to supply is likely to move back to more normal levels. During the period of negative swap spreads of the past year, the average bid-to cover ratio was a relatively low 2.8x. The average ratio from 1983 is around 3.2x, and we would expect to move back toward these levels. Second, a tighter Budget may also limit any further increase in default risk premium being applied to NZ long bond yields relative to swap yields. With the release of the Budget, rating agency S&P confirmed their current sovereign rating of NZ. However, they have kept NZs foreign currency rating on negative watch, with the risk of downgrade if NZs external position does not improve. Rating agency Fitch described NZs Budget as appropriate, while Moodys said NZs Budget supports a path to surplus and reiterated their AAA rating. Finally, we expect economic sentiment to gradually improve and the market to factor in a removal of highly accommodative monetary policy. We expect that once the RBNZ gets underway they will move steadily toward a 5% peak in the OCR. In line with this view, we anticipate some flattening in the curve from current historically steep levels.

30/06/1998

30/06/2000

30/06/2002

30/06/2004

30/06/2006

30/06/2008

30/06/2010

So urce: Bloo mb erg

NZ GDP (qoq %)

In summary, the recent decline in NZ swap spreads to negative territory was driven by a combination of a pick-up in Govt debt issuance, marginal increase in Govt default risk, and severe steepening in the yield curve. The NZ swaps and bond markets are also in some ways quite separate with different customer/investor bases, responding to different demand/supply dynamics. The ability to engage in a relative value trade (EFP), across the two markets, though theoretically possible, is more difficult in practise. Cross market anomalies can therefore persist for some time.

What drove the normalisation?

Bid-to-cover at NZ bond auctions
1200% 1000% 800% 600% 400% 200% 0% 15/01/2009

15/07/2009

15/01/2010

15/07/2010

15/01/2011

Bid-to-cover ratio (%)

Source: NZ DMO

Strategy implications
Therefore, we expect that long end swap-bonds spreads will move in the direction of more normal levels. The 15year average is around 60bp but does disguise some marked trends. In addition, the proliferation of C.S.A agreements, post the Global Financial Crisis, that help to mitigate counterparty risk, may also mean that long-term average swap spreads have shifted lower. However, given the three key drivers, discussed above, are all moving in the same direction, we expect swap spreads to remain positive and move gradually higher in the year ahead. This should see increased issuance in areas such as Kauri bonds by AAA rated Supranationals, Sovereigns and Agencies, as their swap-referenced yields will appear more attractive to investors relative to NZ Government bond yields. Borrowers should also consider the risk of higher swap rates as interest rates rise and swap spreads relative to bonds likely increase.
kymberly_martin@bnz.co.nz

While Government bond issuance has continued apace, in recent weeks there was a spike in demand relative to supply. This brought to an end a period of below average bid-to-cover ratios at auction that had endured since early 2010. The low demand relative to supply spanned the period of negative swap spreads. The recent spike up in demand may partly be attributable to a broadened investor base. Anecdotal evidence suggests that some recent demand for NZ Government bonds may have come from areas such as Asian sovereign wealth funds, diversifying their holdings. In addition, the curve has also flattened slightly in the past few weeks, coinciding with the move in swap spreads back to positive territory. The 2s-10s swap curve has flattened from a peak of 2.14% in mid April to close to 1.9% now.

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Contact Details
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