Britannia Radio

Swap spreads turn negative

By Michael Mackenzie in New York

Thursday Oct 23 2008 17:55

The turmoil in the financial markets has taken hold of the strategically important trade in long-term interest rate derivatives, pushing rates to levels once thought to be a "mathematical impossibility".

Such interest rate swaps are the most widely traded over-the-counter derivative and are crucially important for insurers, pension funds and other companies that need to fund liabilities decades into the future.

Investors use swaps to lock in interest rates for 30 years or more, trading a floating rate, based on the London interbank offered rate, for a fixed rate, typically based on US Treasury yields, plus a premium, called the swap spread, which reflects the risk of trading with a private counterparty as opposed to the government.

On Thursday, the 30-year swap spread turned negative after briefly flirting with such levels earlier this month. This implies investors are somehow reckoning that they are more likely to be paid back by a private counterparty than by the government.

"Negative swap spreads have been considered by many to be a mathematical impossibility, just like negative probabilities or negative interest rates," said Fidelio Tata, head of interest rate derivatives strategy at RBS Greenwich Capital Markets.

Traders and analysts believe this reflects aftershocks from the demise ofLehman Brothers and capital constraints at surviving banks rather than a loss of confidence in the US government.

The Lehman bankruptcy is important because it led to the termination of outstanding contracts. With many participants scaling back activities, investors have had trouble filling holes in their portfolios, upsetting the normal relationship between the swap spread and the "risk-free" Treasury yield.

For much of this year, the 30-year swap spread averaged between 30 and 55 basis points over the 30-year Treasury yield. It closed at 15bp on Monday, 0.5bp on Tuesday and a "negative" 4.25bp on Thursday. Implied 30-year swap spreads for Europe and the UK have been negative since the demise of Lehman.

"Insurance companies and pension funds woke up and realised that their existing swap contracts had been torn up and that they needed to replace them," said William O'Donnell, UBS strategist.

He said the collapse in swap spreads also reflected the prospect of a rise in Treasury supply. Greater Treasury debt sales tend to narrow the difference between Treasury yields and swap rates.