Want To Trade The Interest Rate Swap/Treasury Bond Spread? Think Twice.

By | November 19, 2015

Scalper1 News

The spread between five-year OTC interest rate swap yields and five-year Treasury yields has recently turned negative. In theory, this spread measures the cost depositors charge for bearing the extra credit risk of bank deposits. Should you buy this spread, expecting a return to positive spreads? Trades based on the yield economics are risky in the very inefficient IRS market. The press has awakened to an unexpected development on the long end of the interest rate swap (“IRS”) yield curve. IRS rates for 5-year maturities and longer are trading below Treasury rates for the same maturities. This spread is, in theory , a measure of the difference between the credit risk of Treasury debt and unsecured wholesale unsecured bank debt of the same maturity. But in reality this spread is obviously vulnerable to divergence from the theory. The chart shows the 5-year swap rate against the 5-year constant maturity Treasury curve over the past six months. A few things stand out. The IRS yield exceeded the Treasury yield during most of the period. The problem, if we should call it that, begins with the early-October run-up in Treasury rates, as displayed in the graph below, produced by FRED, the St. Louis Fed’s database. Several issues that distinguish IRS markets from Treasury markets might have come into play at that point. What are the trading implications of this development? With the listing of 5-year IRS futures by the CME Group (NASDAQ: CME ), it is possible for non-banks to trade the expected spread between 5-year IRS futures (CBOT : F1U) and 5-year Treasury note futures (CBOT : ZF). (click to enlarge) But the negative cash market spread is telling us that an analysis of the credit risk of prime banks is secondary in trading this spread successfully at present. There is no assurance that buying this negative spread will return a quick profit. Economic forces will be secondary determinants of this spread until the OTC IRS itself trades in a secondary market. At the moment, determination of swap rates is the dominion of roughly 20 large banks that face a multitude of other problems. On the other hand, if you meet these conditions: You are a non-bank corporate or financial institutions borrower, but not an IRS dealer. You can finance your operations at interest costs tied to 6-month LIBOR for the foreseeable future. You have a productive use for long-term debt. Run – do not walk – to your nearest swap dealer and pay fixed on an appropriately sized IRS at a negative spread to Treasuries. OTC swap dealers do provide long-term interest cost protection. It will take five or more years for the swap to unwind and provide the cheap long-term cost of money that you seek, but if that is consistent with your business plan, very little can go wrong. [But if there is any chance that you will change your mind (as several municipalities have done), do not enter this transaction. There is no more iron-clad commitment than an IRS. It is not a bond. You can’t buy it back.] The IRS/Treasury spread is a close relative of the TED Spread [difference between the Treasury bill rate and the Eurodollar (LIBOR) rate of the same maturity.] The TED spread is thought to represent the cost to prime London banks of the added credit risk their short term unsecured debt represented relative to that of the U.S. Treasury. In spite of the problematic history of LIBOR pricing, the TED spread has been and will remain, positive. LIBOR is indeed problematic. Within months of the listing of Eurodollar futures (CME : ED), LIBOR became something other than a market yield. London offered the services of the British Bankers Association in polling specified bank employees in London branches to form a poll on LIBOR. This was not good news for believers in market forces. Most readers are aware of the sorry history of this “LIBOR fixing,” with billions in legal settlements of lawsuits resulting from manipulation of this poll on a market price. If you are not familiar with the LIBOR scandal, read here . LIBOR, the interest rate index fundamental to the determination of swap values, is an estimate of the market yield on unsecured wholesale bank debt. These bank debt instruments, London branch deposits, are securities in the same sense that Treasuries are. And nobody questions that they are riskier than the U.S. Treasury bills. But as we learned, the LIBOR rate is not exactly the price at which these deposits are traded. For example if, for some foolish reason, roughly 10 of the 18 banks asked on a daily basis to provide LIBOR, undertook to bring three- and six-month LIBOR rates below the Treasury rates at those maturities, they could make that happen without a single transaction. We learned from the LIBOR scandal that 18 large banks have unfortunate employees that have been cursed with the task of providing an answer to the following imponderable question every day. ICE LIBOR Question: “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 am London time?” There is no compensation this side of $1 billion that would entice me to accept this job. The reason is simple. This person is very likely to be sued, perhaps criminally, and will have no credible economic explanation for the values provided. Consider the plight of this person if employed, for example, to produce Citibank’s (NYSE: C ) rate. Of the 18 banks polled each day, 17 know at what price Citibank could borrow under the (poorly specified) circumstances of the question. The only bank that does not is Citibank, which cannot lend to itself. Worse, none of the 18 banks know the minimum rate at which Citibank could borrow, which is the number requested. Yet this Citibank must make this guess every day. Given the disastrous events of recent years and the legal jeopardy described above, I am sure the LIBOR providers do their very best to guess this rate correctly these days. There is little likelihood that LIBOR is anything other than a very good guess at the 11:00 AM cost of bank money in London. The likelihood of LIBOR falling below the Treasury rate is nil. Why is the IRS rate different from LIBOR? Mostly because it is more obscure. Nobody is going to jail because the spread is out of line right now. But it is no less important to the dealer banks. Various authors search for an economic explanation for an IRS rate less than the Treasury rate. Resist this urge. There is no economic answer. The dominant economic explanation in the press doesn’t wash. This explanation posits that these unseemly low IRS rates are the result of the incredibly safe IRS clearing houses. The argument goes that the new OTC clearing facilities are less credit risky than the U.S. government. This dubious notion, it is suggested, is perhaps due to an implicit government guarantee, resulting from exchanges’ designation as “systemically important utilities.” Such explanations are based on a total misunderstanding of the credit risk associated with entering a swap and could not be more mistaken. IRS trades are credit risky. But the credit risk in question has no direct relationship to the IRS yield. The credit risk exists on both sides of the trade. Each party to the trade is at risk to the other. As a result, there is no reason for either side to pay for the credit risk it creates unless its credit risk is dramatically different from its counterparty. This is not the case for the dealer swap transactions upon which market pricing is based. The heart of the matter is that LIBOR swap rates are based on the dealers’ prices in trades with each other. For the specifics of how IRS prices are determined, l refer the reader to a rather terse explanation from LCH:Clearnet , the largest clearer of IRS globally. The root of the pricing problem is that IRS trades, like LIBOR, are not negotiable and thus inevitably guesses. LCH:Clearnet’s methodology does not specify the guesser. I have no reason to doubt that the effort to guess the market price of IRS is as sincere as that for LIBOR. I expect that the negative value of the Treasury/IRS spread caught the dealer’s attention and that the optics did not amuse them, another reason to believe the prices are close to the market’s transaction prices. Here is a short list of market issues that could be leading to the negative spread. (click to enlarge) Liquidity. As the Chart below indicates, the volume of cleared IRS has been falling steadily for the past two years. This suggests fewer dealer trades. JasonC also shows that U.S. dealer notional principal amounts (NPA) have been falling steadily over the same period, another indicator of falling liquidity in this market. The market may have become less efficient, and the dealers’ ability to change pricing as market conditions change may be reduced. Valuation Issues. An IRS (if you set the credit risk between parties aside) is a zero-sum game. Every dollar one trader earns as IRS rates change is lost by another. Since most IRS are trades between the 10 largest dealers, I cannot imagine that the trading community as a whole benefits directly from unchanging interest rates, whether up or down. The same may not be said of individual dealers of course, so the possibility that one or more specific banks is losing value as interest rates rise is real. But I don’t think one or a few banks losing money would slow the rise in IRS long-term rates. Changing rates do have a substantial and important indirect negative effect on all banks. There is a reporting issue associated with changing rates. Bank derivative risk reporting basically involves two measures of performance. Banks report their derivatives NPA and derivatives net asset value (cash value in the case of a hypothetical sale.) A run-up in interest rates has a substantial effect on every bank’s net asset value. It has no effect on the net asset value of the system as a whole, since every dollar earned in the zero-sum swap market is also lost elsewhere. But regulators base their estimates of the risk exposure of the banks’ swap books on this number. And both negative market values and positive market values rise as rates change. Even an increase in a bank’s swap book net asset value is a negative for bank regulators. This factor could create an incentive to moderate changes in swap rates, especially if there were a substantial probability that these increases would be reversed. The Whack-a-Mole Factor. Finally, I think it would not be surprising if individual banks are as reluctant in the IRS market as they are in the LIBOR market to release estimates of market yields higher or lower than the herd’s reported average. IRS estimated rates are no less subjective than LIBOR rates, since there are no secondary market prices. There has not been a scandal in IRS markets analogous to that in the LIBOR markets. In fact, this is one of the few OTC markets in which there has been no such scandal. But who wants to be first? All in all, I do not find this temporary divergence of IRS rates from their theoretical relationship to Treasury rates very alarming. None of my suggested reasons leads to any kind of financial disaster. But the absence of pricing efficiency in the IRS market is another of the gradually collecting indicators that this market is more expensive to operate and less efficient in performing its risk-transfer function than we should expect. And trading this spread based on bank credit risk estimates is dangerous right now. As presently constituted, the IRS market is hazardous to traders other than dealer banks and their customers. And that is its most important flaw. Scalper1 News

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