Interest Rate Swap Spreads

Brought to us by two monetary system experts, this one’s going to get a bit more technical than our usual content. So, grab a strong cup of coffee or a high proof spirit and find a quiet place to read.

It may also help to dig into the first section of our “On Inflation vs Deflation” (Lacy Hunt’s view) to help clarify the omnipresent headline “money printing is inflationary” narrative (hint: it’s not).

For those without a PhD in econ, here’s a simplified explanation of Interest Rate Swap Spreads:

There’s two parts:

1. The ‘Interest Rate Swap’

2. And the ‘Spread’

An ‘Interest Rate Swap’ is simply a contract between two parties to exchange a Fixed Rate contract for a Floating Rate contract (floating rate is typically LIBOR). “The “swap rate” is the fixed interest rate that the receiver demands in exchange for the uncertainty of having to pay the short-term LIBOR (floating) rate over time.”

The ‘Spread’ part, is simply the difference between the fixed rate in the Interest Rate Swap agreement and a US Treasury security of the same maturity.

According to PIMCO, “Initially, interest rate swaps helped corporations manage their floating-rate debt liabilities by allowing them to pay fixed rates and receive floating-rate payments. In this way, corporations could lock into paying the prevailing fixed rate and receive payments that matched their floating-rate debt. (Some corporations did the opposite – paid floating and received fixed – to match their assets or liabilities.) However, because swaps reflect the market’s expectations for interest rates in the future, swaps also became an attractive tool for other fixed income market participants, including speculators, investors and banks.”

Here’s what the experts have to say about the Interest Rate Swap Spread chart (remember, this is the spread between the two securities, an Interest Rate Swap and a US Treasury).

Maroon Macro

Historically, most interest rate swap spreads have been positive (investors asked for a premium vs US Yields in order to take on the risk of paying LIBOR)

A financial market participant may be able to arbitrage a positive interest rate swap spread, narrowing it in the process, by

1. Paying the LIBOR (a floating rate) on an interest rate swap,

2. Receiving the fixed rate, and

3. Selling short a US Treasury bond of the same maturity by lending cash against it in a reverse repo agreement. (Note: In this example, a Reverse Repo is simply the mechanics of selling short a US Treasury.)

Editor's Note: Dylan is talking about a trade in the above (not just the Swap Spread). 1&2 comprise the ‘Swap’ agreement. Adding 3 becomes the arbitrage trade.

To simplify, the investor pays the floating rate and receives a fixed rate. Therefore, they take on the risk that the LIBOR rises higher than the fixed rate they receive. So, if rates rise, they have to pay the increase in LIBOR (floating), but given that the treasury is shorted, they make money as bond prices fall (inverse relationship between rates and bond prices).