Tuesday, October 21, 2008

30-year swaps: It looks like we have a bad transmitter

(Accrued Interest) The 30-year swap spread fell as low as 0.5bps today, closed at 3bps. 3bps! Three. One less than the number of legs on a AT-AT. Equal to the number of good Star Wars movies. If you don't believe me that municipal spreads are stupid, at least believe me that a 3bps spread on 30-year swaps is stupid.

To translate... swap spreads is the yield differential between Treasury bonds and the fixed leg of a fixed-floating interest rate swap. Remember that any interest rate swap has to have a bank or other financial institution standing in the middle. With the world scared out of their minds over counter-party risk, how is this spread at all-time tights!?! By comparison, 2-year swaps have a spread of 104bps, and traded as high as 165bps earlier this month.

This strange anomaly is just another example of what happens when leveraged investors are desperate to unload bad trades into a highly illiquid market. Over the last 2 years, there were many "range notes" sold that referenced the slope of 10-year and 30-year swaps. Now that trade isn't looking so hot and people want to hedge.

Lots of people rushing to leave the building, but a small door of liquidity, and a spread of three is the result.

This just reiterates what I said the other day about leverage. The market can't act "normal" when fresh capital is hard to come by. You should still buy bonds based on fundamentals, but bear in mind that it may take a while for fundamental analysis to pay off.

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