Since interest rate swaps became common in the 1980s, the conventional wisdom has been that the interest rate swap spread over Treasuries has been a good proxy for bank funding costs. This assumption was and still is widely used, especially by banks who are not regular issuers of bonds and long term certificates of deposit. If this conventional wisdom is true, why has the 30 year interest rate swap spread to Treasuries been negative on 801 days since the spread first turned negative on October 24, 2008? This blog explains.
The graph below shows the 30 year spread between the interest rate swap yield and U.S. Treasuries as reported by the Federal Reserve on its H15 statistical release:
The 30 year swap spread was first reported as negative on October 24, 2008, about 6 weeks after the September 14 announcement by Lehman Brothers that it would file for bankruptcy. The 30 year spread has been negative on 801 days, and it has been continuously negative since January 7, 2009.
Financial press reports were intensely focused on the 10 year swap spread when it first turned negative on January 21, 2009. Since then, the 10 year spread has been negative on 67 days, predominantly in the March-April 2010 period as shown below:
If interest rate swaps are a good proxy for the marginal funding costs of commercial banks, how could these marginal funding costs have turned negative relative to the U.S. Treasury, which (at least until recently) was considered riskless by most observers?
Five Reasons Why Interest Rate Swap Spreads Can Be Negative
There are five primary reasons why interest rate swap spreads can be negative:
- U.S. Treasury yields reflect the payment of principal at maturity, but interest rate swap yields do not.
- U.S. Treasury bonds could potentially suffer losses of up to 100% of principal, but interest rate swap losses due to the default of a counterparty like Lehman Brothers generates losses that are equal only to the cost of replacing the swap position
- Interest rate swap positions are normally subject to netting with each counterparty and to collateral requirements, but U.S. Treasury bonds are not.
- The U.S. Treasury is not riskless.
- To the extent there has been manipulation of the short end of the Libor yield curve, the long end of the swap curve would adjust downward as well.
We discuss each of these issues in turn.
Payment of Principal at Maturity
Comparing the yields on interest rate swaps with yields on U.S. Treasury bonds is not an apples to apples comparison because the bonds require the payment of principal and the swap contract does not, because the notional principal on the fixed and floating sides nets to zero. For this reason alone, the structure of the swap is a lower risk structure than a bond.
Differential of Amounts at Risk
Because of the point above, the maximum potential losses on a U.S. Treasury bond could be as much as 100% of principal. At this writing, the government of Greece is exploring a restructuring that could trigger losses of as much as 70% of Greek government bond principal, so the point is not an academic one. The amount at risk on the interest rate swap varies from zero (if interest rates don’t move in a flat yield curve environment) to the replacement cost if interest rates make a major move during the life of the swap. In the latter case, if a counterparty defaults, the amount at risk is the cost of replacing the swap. Except for extreme interest rate movements, this is a far smaller amount than the potential credit losses on a government bond as a percent of notional principal.
Impact of Netting and Collateral
For decades, most interest rate swap market participants have agreed to netting in the case of default by one of the parties to the swap, and both parties typically post collateral if the net exposure to the other party goes beyond certain levels. If collateral is properly maintained, this design would minimize credit losses on interest rate swaps still further.
U.S. Treasury Risk
The U.S. Treasury was long viewed as riskless, but the last minute resolution of the debt ceiling negotiations on August 2, 2011 and the on-going potential for a default by the U.S. Postal Service make it clear that the U.S. Treasury can default like any other entity. Indeed, the 22 year history of the 1 year default rate for the United States from Kamakura Risk Information Services shows a default rate between 40 and 170 basis points.
Impact of Libor Manipulation
On August 25, 2011 Charles Schwab filed this lawsuit alleging that major banks had conspired to manipulate U.S. dollar Libor, holding it below its true levels:
In a rational market, those banks who were knowledgeable about the alleged manipulation would lower the fixed rate side of the swap over time if the manipulation of the floating rate side of the swap were expected to continue for an extended period of time.
The conventional wisdom that the interest rate swap yield curve is a good proxy for commercial bank funding costs is false. For the five reasons explained above, the credit risk profile of an interest rate swap is substantially different from the credit risk of a U.S. Treasury bond. The net impact of these five factors can be and has been negative for maturities of 10 years and 30 years. For a weekly study of the implied zero coupon bond yields and forward rates that stem from these differences, please see Kamakura’s implied forecast for the U.S. Treasury and Libor-swap yield curve:
Donald R. van Deventer
Honolulu, February 7, 2012
© Copyright 2012 by Donald R. van Deventer. All rights reserved.