Authors: Charles Gates and Ken Kapner

Interest rate swaps denominated in US dollars (an agreement between two counterparties to exchange a fixed rate of interest for a floating rate of interest for a specific period of time calculated on a notional principal amount) have been in existence since the early 1980s, and most commonly have been priced historically with a floating rate tied to USD Libor (or Libor flat) vs. a single rate of interest fixed at the inception of the swap for the maturity of the swap. Most often the fixed swap rate would be set at a spread over the market yield of the most recently issued Treasury security (commonly referred to as “on-the-run” Treasury) at a comparable maturity.

For instance, if the 5-year on-the-run Treasury were trading at a yield of 2.25% p.a., a five-year USD interest rate swap might be priced at 2.60% fixed per annum vs. 3-month Libor flat for a maturity of 5 years. The 3-month LIBOR resets every three months. The difference between the fixed rate on the interest rate swap of 2.60% p.a. and the corresponding Treasury yield of 2.25% p.a. is +0.35% p.a., or a positive spread of 35 basis points. The positive spread has traditionally represented credit and hedging costs associated with the swap. The introduction of central clearing has, in theory, removed any associated counterparty credit risk. (For more information on central counterparties see https://www.gfmi.com/articles/understanding-central-counterparties-ccps/).

Hedging a swap or a swap portfolio requires the buying or selling of a US Treasury note/bond, the repo market, and the financing/earning on cash outflows/inflows. The following diagram illustrates a swap dealer receiving fixed, paying floating. To hedge the fixed leg of the swap, the dealer sells the US Treasury short. Since the dealer does not own the Treasury, they need to temporarily borrow the security in the repo market. The hedging costs will be taken into account and impacts the spread. More importantly, as discussed later in this blog, new capital requirements have been introduced for the repo markets. These costs also have to be taken into account.

If the fixed rate on the swap had been priced at 2.05% p.a., the spread on the swap would have been described as a “negative spread” of 20 basis points). This is because the fixed rate on the swap is 20 basis points below the Treasury yield. We are assuming in the foregoing examples that the floating rate in the interest rate swap is the same in both cases, i.e., Libor flat.

Historically, USD swap spreads traded at a positive spread against Treasuries, as demonstrated in the following tables (source: Board of Governors of the Federal Reserve System H.15 release, in the Economic Policy Review, Federal Reserve Bank of New York, “Negative Swap Spreads”, authors Nina Boyarchenko, Pooja Gupta, Nick Steele, and Jacqueline Yen).

In the above chart on the left, we see a time chart for 10-year Treasury yields and 10-year swap rates – and in the blue shaded portion the spread between those two rates. The scales for the two rates are on the right hand vertical (0 to 8% for the actual Treasury yields and swap rates), and the scale for the swap spread is on the left hand vertical (-50bps to +150 bps). If you look closely, you can see that the 10-year swap spread dips negative right after January 2010, reverts to zero, and goes more negative just before January 2016.

The chart on the right hand depicts interest rate swap spreads for 2-, 5-, 10- and 30-year swaps over the same time period. Thirty-year swap spreads plummet below zero at the end of 2008 – ultimately going more than 50 bps negative – and both 5- and 10-year spreads go negative by 2016, albeit to a much lesser extent than the 30-year spreads.

The Bloomberg screenshot below (from June 14, 2016) shows the 2 ½% Treasuries of 05/15/46 (30 year maturity) trading at a yield of 2.418% (see left hand column below about half way down), and the 30-year swap rate of 1.9385% (figure in white in the “Swaps” box halfway down the page, just left of middle). As you can see, the swap spread is a negative 48 basis points. Comparing the comparable rates at 3, 5 and 10 years, you see a positive swap spread at 3 years of 11 bp (0.9521 – 0.846), and negative swap spreads of -2 bp at 5 years, and -12 bp at 10 years. This distribution looks similar to that in the chart above.

Source: Bloomberg June 14, 2016

Since the advent of 30-year swap spread turning negative back after the crisis, there have been a variety of reasons offered for negative swap spreads. Some of these include:

- Liability driven investors (LDI) selling their longer dated fixed income securities and substituting them with interest rate swaps. The LDI would receive fixed and pay floating. Since this occurred with extensive volume, the interest rate swap dealers adjusted their spread accordingly, i.e., they reduce it until the spread eventually went negative
- Convexity hedging in the MBS market has been reduced. Prior to the crisis, Fannie and Freddie would use interest rate swaps to hedge the convexity associated with owning mortgage backed securities. As the Fed now owns roughly half of the MBS, the need for hedging has been greatly reduced.
- New capital charges that have dealers analyzing their return on equity on the swaps book they run. In addition, these capital charges have shrunk the repo market.
- Corporate issuers swapping from fixed to floating, thereby narrowing the interest rate swap spread.

**The Role of Repos in Swap Trading **

Firstly, it is important to recognize that the repo trading desk in a broker/dealer is a profit center. As a repo profit center, it has to earn enough profit to not only cover its expenses, but to also earn a superior – or at least a target minimum – return on capital allocated to the repo desk in order to survive. Otherwise, all else being equal, the firm may well shut down the repo trading activity and allocate the repo capital to other business lines. Following the application of the Supplementary Leverage Ratio (SLR) and other ratios under Basel III, many firms underwent a business review of their repo operations (along with other business lines), and where necessary, reduced their repo activity, pared back less profitable repo activities, and emphasized increased repo ROE targets. There is no single answer to the conundrum of negative swap spreads, but multiple factors emerge from our research and discussions with repo personnel, and different repo firms could reach different decisions, depending upon their own business models, customer profiles, ROE targets and overall business strategy.

Secondly, there is a strong mutual dependence between a firm’s interest rate swap trading and a firm’s repo business. A relatively simple way to envision the swap book is as an irregular and relatively unpredictable inflow of large customer orders to either pay or receive fixed vs. floating at different times and for different maturities, and whose profit driver is a positive difference between the bid-offer spreads for swaps overall in the book. If the book is balanced and a customer suddenly wants to pay fixed (i.e., the dealer is receiving fixed) for 5 years, the swap book runner will quote a price for the customer, but the moment after confirming the deal, will have an interest rate risk that 5-year interest rates will rise and the swap book will incur a loss when the dealer goes out to cover the position by paying fixed at a higher rate.

The solution is to hedge the 5-year interest rate risk by shorting the on-the-run 5-year Treasury, and the cheapest way to do that is to “finance” the short through doing a simultaneous reverse repo through the repo desk (i.e., the repo desk lends the security to the swap desk in exchange for the dirty price of the security, but also taking a haircut on the cash amount). If interest rates rise, the short Treasury position will show gains to offset losses on the swap. When a new 5-year receiver of fixed is found by the swap desk, the swap desk can use that to hedge the original swap, and the swap desk can unwind its reverse repo. In short (no pun intended!), using Treasuries and repos provides the cheapest and most effective method for hedging swap positions, either as the receiver or payer of fixed positions. But distortions in the repo market can create distortions in the swap market.

Finally, several key regulatory changes were enacted in the wake of the crisis which likely impacted repo activity. Boyarchenko et al. stated: “…it appears that executing swap spread trades is now more expensive for dealers than in the past largely because of the amount of capital that dealers must hold against these trades. The amount of capital required is driven principally by the cash product position of the trade rather than the derivatives portion. The SLR requires that the entire repo-financed Treasury position be recognized, while the derivatives portion is recognized only up to the margin posted on, and the potential future exposure of the position.” (p. 11)

For example, the Supplementary Leverage Ratio (SLR) is calculated as *Tier 1 Capital/Total Leverage Exposure*. To help illustrate the need for increased capital, assume the SLR is set at 3%. The ratio is not allowed to fall below 3%. When a repo is executed it gets included in the denominator. Assuming the ratio for this example stands at 3%, the additional increase in the denominator caused by the repo would require a corresponding increase in capital in the numerator. *The additional cost of capital would need to be included in the initial swap transaction thereby lowering the swap spread*.

**Conclusion**

For now, it looks as though negative interest rate swap spreads will remain part of the financial landscape and repo transactions will continue to be an integral part of hedging interest rate swap rate risk. Natural market activity will search for that breakeven spread.