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11 17 2015 | by Victor Xing | Capital Markets

Why did swap spreads turn negative (late 2015)?

The 5 year swap spreads have indeed turned negative.  Many investors have used swaps as a alternative for nominal Treasuries in their daily transactions, and swaps holds several advantages over nominal Treasuries (thus contributing to their out-performance vs. nominal Treasuries):

  1. Frees up balance sheet for other assets such as corporate debt, MBS and EM bonds
  2. Highly liquid – it is easier to unwind large notional swap position than selling nominal bonds
  3. Makes larger notional positions possible – if an investor wishes to initiate an interest rates position in less than a year in maturity, the DV01, or interest rate risk, may drop notably (thus one needs to have a large notional position to achieve a meaningful DV01).  Having couple hundred million tied up in a short-term swap position is inefficient
  4. Precise control over maturity or forward starting date.  Investors can use swaps to initiate forward positions such as 3y3y or 10y10y

It is true that a few articles argued that tightening or negative spreads imply the U.S. government is less creditworthy than contracts with financial institutions, but I would like to highlight that swaps are centrally cleared via CME or LCH, thus significantly reduced (some would argue “removed”) counter-party risk (or credit risk).

Finally, given the liquidation of UST positions ahead of the December FOMC, Treasury notes have further under-performed relative to swaps (Treasury yields rise faster than swap rates).

5 year and 30 year swap spreads
5 year and 30 year swap spreads

Next article11 16 2015 | by Victor Xing | Central Banks

Who is responsible for oversight of the Federal Reserve