Posted in the Financial Times by Michael Mackenzie:
A year after the collapse of Lehman Brothers, which sparked chaos across derivatives markets, one striking dislocation persists; a negative 30-year interest rate swap spread.
Prior to the demise of Lehman, the idea of a negative relationship between swaps and government bonds was considered unfathomable.
The swap spread reflects the risk premium for money market rates over Treasury yields. A negative swap spread implies that the credit quality of Treasury debt is lower than that of banks transacting in the money market.
Now, after a year of negative 30-year swap spreads - which, at its quote of about minus 17 basis points, shows little sign of turning positive - some in the market are becoming comfortable with the notion, particularly as the US government continues to fund a surge in borrowing.
Fidelio Tata, derivatives strategist at RBS Securities says questions are being asked in the market about the assumption governing whether a 30-year swap is riskier than a 30-year bond.
"You don't exchange the principal in a swap and the payments are marked to market, and you could argue that is a lower risk than lending money to the US Treasury for the next 30 years," he contends.
A year ago, the 30-year spread was trading at 45bp above the 30-year bond yield. The spread narrowed below 20bp in October as investors scrambled to replace hedges that were cancelled by Lehman's bankruptcy. With Lehman's swap contracts void, that ruptured one side of trades involving the derivative, forcing counterparties to replace them and stem losses.
One of the features of the interest rate derivative market before last summer was that less margin for trades was exchanged between dealers.
"Therefore, when the contracts written by Lehman disappeared, some dealers were forced to take significant writedowns," said analysts at Banc of America Securities.
"This highlighted the under appreciated risk of counterparty exposure in the interest rate derivative markets."
The spread briefly turned negative in late October, driven by dealers having to hedge curve trades and a welter of structured notes, which required hedging once the 30-year swap spread neared zero.
By mid-November the spread was trading at minus 20bp and that move forced renewed hedging of positions, which sent the spread beyond minus 50bp later that month.
Compounding all of this, was a strong demand by pension funds and insurers to receive a fixed rate of interest in 30-year swaps, rather than commit cash to buy bonds, as the fear of deflation accelerated.
Aside from a brief period of positive trading at the start of the year, the 30-year spread has spent most of 2009 in negative territory. This reflects how balance sheet constraints at banks and a dysfunctional repurchase or repo market, which helps fund trades between swaps and Treasuries, has impeded the ability for many investors to profit from the dislocation normalising between derivatives and bond yields. These so-called relative players were decimated by the market volatility and have not returned in a substantial form, say dealers.
"Very few investors can take advantage of the arbitrage between swaps and Treasuries, as you need a balance sheet to put on that trade," says Mr Tata. "The repo market is still dysfunctional and you need access to repo financing for a long period."