The Positives of Being a CFA® Charterholder in a Negative Swap Spread World
“Hmm…probably during my CFA Level II studying.” That is my response when my boss asks me how I became familiar with the swaps market. We had been discussing a research piece from an investment bank analyzing a curious recent phenomenon—US swaps spreads were negative, while TED spreads were positive. Had I been sitting in the same chair only two years earlier, my head would have been spinning.
Swap spreads and TED spreads are interest rate spreads that serve as important benchmarks for global borrowing costs. Prior to studying for the CFA, I had only a vague understanding of these terms, despite several years of experience in the industry. Not having a thorough comprehension of such concepts left me at a considerable disadvantage. It’s easy to get lost in finance: the marketplace is filled with confusing acronyms, and research analysts never seem to tire of their love for jargon. Having a strong grasp of the basics is vital.
What Are Interest Rate Spreads?
Simply put, an interest rate spread is the difference between a particular bond yield and a benchmark yield. Spreads can be viewed as a risk measure and the “building blocks” of a particular bond. Two of the most watched spreads are the TED spread and swap spread.
TED Spreads: The TED spread equals three-month Libor (Libor stands for the London Interbank Offered Rate, and is the rate at which a group of the world’s largest commercial banks lend funds to one another) minus the three-month Treasury bill rate. It is a benchmark spread used to evaluate credit risk in the overall economy, as well as a measure of counterparty credit risk, particularly reflecting credit risk in the global banking system.
Swap Spreads: The US swap rate is the fixed interest rate paid in exchange for receiving a floating (short-term Libor) rate. The plot of swap rates across various maturities is the swap curve; the difference between the swap rate and corresponding US Treasury yield is the US swap spread, with the spread across maturities reflected in the US swap spread curve.
The swap spread is a measure of credit and liquidity risk. Historically, swap spreads tended to be positive across maturities, reflecting the higher credit risk of commercial banks vsersus risk-free US Treasuries. Interestingly, over the last several years, the swap spread has been negative (inverted curve) for longer maturities. US swap spreads represent the incremental funding cost over government bond yields; logically, a negative swap spread does not make sense, as it implies that a corporation is less risky than the US government. However, swap spreads at any given time will be influenced by other factors, including supply/demand conditions and market liquidity. We are currently seeing longer dated swap spreads influenced by these “other” factors.
Is There an Arbitrage Opportunity?
In theory, yes. An investor could buy a 30-year Treasury and enter into a swap to pay fixed 30-year swaps (receive floating Libor). The TED spread is positive, so that same investor can then swap her floating rate exposure for short-term Treasury bills and capture the “risk-free” differential.
In practice, this has not happened. Tightened government regulations, higher capital requirements, and reduced dealer balance sheet capacity have increased funding costs and the ability of investors to exploit the arbitrage. Structural declines in demand for net-pay fixed positions, increased institutional demand for net-receive fixed, and an increasing supply of US Treasuries have also contributed to a supply/demand imbalance. Thus, while swap rates are based on interest rates (Libor, Treasury yields), the influence of market technicals (liquidity, supply/demand, bank credit quality) has led to deviations from what is otherwise expected.
What Does CFA Institute Say about Negative Swap Spreads?
Very little. Negative swap spreads first arose post-financial crisis in 30-year maturity swaps, and in late 2015 the phenomenon occurred with 10-year swaps (and shorter maturities as well). What happens in the future remains an open question.
So Is the CFA Program Curriculum Still Valid?
Definitely. In order to understand what is occurring, it is important to first recognize established orthodoxy with regard to the swaps market. The CFA Program curriculum explains the importance of the swap spread curve as a measure of default risk of private entities (commercial banks) and a benchmark for determining credit risk in other assets. Coupled with the fact that it is unregulated (not controlled by governments and thus more comparable across countries) and that there are more maturities with which to construct a yield curve (versus government bonds), swap spreads remain a popular fixed-income benchmark. However, when theory meets reality, we see the importance that factors such as liquidity, supply and demand, government regulations, and so forth have on the market.
As for myself, absent understanding the basics of swap spreads, it would not have been possible to understand the dislocations today. This base understanding is what the CFA Program curriculum provides. It does not represent any specific point in time; instead, it is incumbent on investors to take the theory and apply it to reality.
About the Author
Andrew Bekker, CFA, is a senior investment analyst at Kilimanjaro Advisors, LLC, a private investment firm located in Boca Raton, Florida. He focuses on analyzing performing and distressed corporate credit opportunities across a diverse range of industries. Mr. Bekker is a member of the CFA Society of South Florida. He received his BS in Finance and International Business from the Stern School of Business at New York University.