Credit crunch upsets 30-year rate swaps
Credit crunch upsets 30-year rate swaps
By Michael Mackenzie
Published: October 23 2008 19:14 | Last updated: October 23 2008 19:14
The turmoil in financial markets has taken hold of the strategically important trade in long-term interest rate derivatives, pushing rates to levels once thought to be a “mathematical impossibility”.
Such interest rate “swaps” are the most widely traded over-the-counter derivative and are important for insurers, pension funds and other companies that need to fund liabilities decades in the future.
Investors use swaps to lock in interest rates for 30 years or more, trading a floating rate, based on the London interbank offered rate (Libor), for a fixed rate. The latter is typically based on US Treasury yields, plus a premium, called the “swap spread”, which reflects the risk of trading with a private counterparty, as opposed to the government.
On Thursday, the 30-year swap spread turned negative after briefly flirting with such levels earlier in the month. This implies investors are somehow reckoning that they are more likely to be paid back by a private counterparty than by the government, which can print money.
“Negative swap spreads have been considered by many to be a mathematical impossibility, just like negative probabilities or negative interest rates,” said Fidelio Tata, head of interest rate derivatives strategy at RBS Greenwich Capital Markets.
Traders and analysts believe this unprecedented state of affairs reflects aftershocks from the demise of Lehman Brothers and capital constraints at surviving banks – as opposed to a loss of confidence in the US government.
The Lehman bankruptcy is important because it led to the termination of outstanding contracts, many highly complex.
With many participants scaling back activities of all kinds, investors have had trouble filling holes in their portfolios, upsetting the normal relationship between the swap spread and the “risk-free” Treasury yield.
For much of this year, the 30-year swap spread averaged between 30 and 55 basis points over the 30-year Treasury yield. It fell from 15bp on Monday, to zero on Tuesday and was “negative” on Thursday. Implied 30-year swap spreads for Europe and the UK have been negative since the demise of Lehman.
“Insurance companies and pension funds woke up and realised that their existing swap contracts had been torn up and that they needed to replace them,” said William O’Donnell, UBS strategist. He said the collapse in swap spreads also reflected the prospect of rising Treasury supply.
Copyright The Financial Times Limited 2008
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