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By Alex Temple, portfolio manager at ECM Asset Management
Since the start of the year the spread between the 5-year EUR swap and 5-year German Government bond has widened from around +47 bps to +51bps, it has however been as low as +30bps and peaked at +61bps. This spread is known as the swap spread.
Corporate bonds generally price relative to their respective risk free government curve. In the U.K. this means a credit spread over gilts, in the U.S. Treasuries and in the eurozone German bunds. Many of our strategies are duration hedged which means we hedge the interest rate risk.
One way to hedge a bond’s interest rate risk is to sell government bond futures. The contracts are very liquid, exchange traded and the bid-offer is tight, however they only cover a limited number of points on the curve with the U.K. having just one liquid contract (10-year). The deliverable on which the futures contracts are based is known as the cheapest-to-deliver bond and this varies according to supply and demand. In the last week the CTD for the U.K. 10-year future has fluctuated between a 9-year and a 12-year bond which makes it harder to hedge with.
As many of our funds are Euribor based we generally use interest rate swaps to hedge the interest rate risk. Instead of selling bond futures we pay fixed in an interest rate swap. Interest rates swaps usually trade electronically and whilst they are bilateral trades between the fund and a bank, the market is moving towards central clearing.
As we are hedging bonds that are priced off the government curve with a swap priced of the swap curve we are exposed to the spread between the two curves, known as the swap spread. More specifically, as we are long a bond and short swaps we should benefit from a widening in the swap spread. This means that if government bonds rally, and swap rates remain unchanged then our corporate bonds should go up in value and our hedge will remain unchanged.
To better understand swap spreads we need to look at the drivers:
Swap Bank Credit Risk
While much of the credit risk in the interest rate swap itself is mitigated by the nature of the product, it is unfunded and collateral is generally posted by both parties to cover mark to market movements, the swap curve is built from Libor (unsecured lending) rates and these are set by a panel of banks hence the swap spread reflects bank credit risk. This is the main reason that swap yields are higher than government yields. The correlation between the credit spread of EB00 (Euro Financial Corps index) with 5-year EUR swap spreads, from 2000 until now is 0.76.
Swap Bank Liquidity
As well as bank credit risk, swap spreads reflect interbank stress. This is because the Libor instruments used to build the swap curve reference six month Libor rates (three month Libor in the U.S.). In periods of stress banks charge a higher premium for term funding which leads to higher swap rates and hence swap spread widening. The three year LTROs introduced by the European Central Bank at the end of 2011 relieved pressure in the interbank market with 5-year EUR swap spreads tightened from +100bps all the way to +35bps.
Curve Slope
When curves are steep, corporate issuers tend to swap their issuance into floating which means they are receivers of fixed rate swaps which tightens swap spreads.
Government Finances
Government bond supply and demand is, in part, driven by its budget balance. With a fiscal deficit in the U.S., U.K. and Germany, government bond supply implies tighter spreads however the flight to quality from the eurozone crisis and central bank bond buying programs have pushed swap spreads wider. This widening is exacerbated as the panel of Euribor banks is made up of banks from the whole eurozone as well as a handful of non-eurozone banks.
As Euribor based funds hedged with swaps benefit from swap spread widening and swap spreads widen in a risk-off environment, hedging with swaps should help reduce volatility in a stressed market.
This year’s move wider in EUR swap spreads is reflected in the excess swap returns for ER00, a European Corporate Bond Index, where the YTD excess swap return is +73bps and the YTD excess government return is +43 bps.
While much of this year’s move wider in swap spreads has been driven by initial uncertainty around the partial repayment of the 3-year LTRO and continued pressure from the eurozone crisis, expectations of European interbank stress are contained by the ECB’s actions and should keep a lid on the type of systemic widening we saw last year. However with increasing financial regulation and the move to central clearing there is risk that bid for liquid collateral puts pressure on spreads to widen. On balance our outlook is neutral on bond swap spreads in the short to medium term.