Q & A with Emily Hollis

Emily Hollis
May 21, 2010 | COMMENTS

Question: What are swap spreads?

Simply put, swap spreads are the difference between the rates for U.S. Treasuries and market swap rates. Swaps are an integral part of the fixed income market. In this market, investors “swap” their interest rate risk exposure by converting a fixed-rate asset or liability into a variable-rate product.

As an example, the current two-year swap rate is 1.19 percent compared to the two-year Treasury rate of 0.75 percent for a swap spread of 0.41 percent or “41.” The 1.19 percent two-year swap rate is the current market rate that an investor would pay given a predetermined nominal principal amount, off balance sheet, for two years in exchange for receiving three month LIBOR, with a quarterly reset. A trade that works very well when rates rise. When the swap spread is added to an on-the-run Treasury yield, it generally represents the rate or yield that one would pay in order to receive LIBOR for a specific term.

More and more fixed income product is quoted at a spread over the “swap curve.” The “swap curve” simply connects the term swap rates over time, similar to the Treasury curve. The swap spread to the Treasury curve is referred to as the credit spread and encompasses the excess return required by investors in order to accept the added risks of investing in non-Treasury investments (spread product). Swap spreads, along with liquidity, industry, or structure specific issues are the main components that make up the total credit spread.

The liquidity portion of the credit spread is difficult to quantify, but should certainly be considered as a factor in the investing decision. Liquidity risk occurs when the bid for a certain type of bond evaporates, which usually takes place in times of high market volatility. The risk manifests itself as wider than usual bid/ask spreads—reducing the price for which a position can be sold. For outright credit exposure, investors expect a higher yield when purchasing bonds of a BBB rated company or structured mortgage backed security than that of AAA.

The market's view of global credit quality along with the increasing scarcity of on-the-run Treasuries and swap supply/demand issues are the main factors that cause swap spreads to change. Two-year swap spreads have increased dramatically during the last 30 days from 11 to 45 as the Europe crisis deepens and chaos hits Greece. Not a surprise.

Emily M. Hollis, CFA, is a partner of ALM First Financial Advisors in Dallas, Texas. Contact Hollis at 800-752-4628 or ehollis@almfirst.com.