- Lenders forced to stockpile more debt by regulation changes
- Swap spreads narrowing worldwide, some have inverted
Banks in Australia held about A$178 billion ($126.6 billion) in sovereign and state government debt in June, according to JPMorgan Chase & Co. To reduce the risk of these holdings, banks often enter into arrangements in the swap market where they pay a fixed interest rate and receive a floating one. Acollapse in the spread between interest-rate swaps and sovereign yields, along with a widening in the premiums on state government debt, is now calling into question these positions
While lending to the government should be far safer than speculating on the direction of interest rates with a bank, some U.S. and U.K. sovereign debt now yields more than swaps. Australia’s 10-year swap spread narrowed to a record 5.4 basis points on Nov. 11, compared with an average of 56 basis points over the past decade. The dislocation reflects falling trading volumes in global bond markets and rapidly shifting benchmark interest-rate outlooks in the U.S. and Europe.
“The breakdown of the relationship between bonds and swap would certainly put some question marks around how banks can best hedge their liquidity books,” given the typical methods banks use, said Martin Whetton, a rates strategist in Sydney at Australia & New Zealand Banking Group Ltd. “Going forward, if you are a bank balance sheet, do you now hedge your liquidity book versus swap? You probably don’t.”
The pressure on swap spreads in the U.S., U.K. and Australia can be explained, at least partly, by regulation that has curtailed the amount of sovereign securities banks are willing to warehouse given the associated costs. On the swap side, a move to central clearinghouses has pushed down costs by eliminating most of the counterparty risks of trading directly with banks. These structural changes have combined with expectations that the Federal Reserve will raise interest rates next month, pushing up yields globally and making it less attractive to hold sovereign debt
Banks and fund managers are finding that the moves in swap spreads are also changing long-standing relationships in the market for debt sold by states and government-backed foreign issuers.
When swap spreads narrow, there is usually an accompanying compression in the gap between yields on government bonds and debt from the states as well as from high-quality offshore borrowers, but that hasn’t happened in the past few weeks, said David Plank, the Sydney-based head of research at Deutsche Bank AG.
“That stresses positions and leads people to become much less confident about the hedges they had in place,” he said. “This will have an impact on the size of positions that people are willing to take, their appetite to hold semis and so on. So it does have material implications, albeit within a relatively small range.”
Swaps are attractive as a hedge because they can be tailored to requirements, such as maturities and coupons, whereas other instruments wouldn’t be as flexible, said Sally Auld, head of fixed-income and currency strategy for Australia at JPMorgan.
“The problem is — what else are you going to use as a hedge and that’s what you have to answer,” she said. “Swaps might not be perfect but then they might be less imperfect than everything else.”
Australia’s 10-year swap spread to bond futures was 10.25 basis points as of 5 p.m. in Sydney, from 22.8 at the end of October.
The yield premium that the nation’s state bonds offer over sovereign paper was at 27.8 basis points on Monday, close to the past year’s average of 31.2, Bloomberg AusBond Indexes show. The gap to the asset swap rate climbed to 29.4 basis points on Nov. 12, the most in data going back to September 2014. In the decade to June 30, the average asset swap spread for semi-government debt was minus 3, according to a Bank of America Merrill Lynch index that was discontinued in the middle of the year.
“When the treasury operations of banks buy semis, they buy them on an asset swap basis so they pay swap and buy the bond,” said ANZ Bank’s Whetton. “Given that there’s been a complete breakdown in the bond-swap relationship, there’s the potential for a
forced unwind of some positions and that will keep swap spreads under pressure.”