Growing appreciation of charms of swaps
Strictly speaking, one cannot invest in an interest rate swap, since it is a bilateral agreement between two parties – for the purposes of this article, an investor and a bank – each of which contracts to make payments to the other on set dates, these payments determined with reference to two different interest rates. Rather, these agreements are entered into as a means of transforming the risk and return associated with a pre-existing investment to meet a specific objective. Typically, interest rate swaps are fixed versus floating, where one party makes payments based on a fixed rate of interest, whereas the other pays according to a floating reference rate, like Euribor.
The swap market developed in the mid-1970s in two forms, currency swaps and single currency interest rate swaps, as a means to allow borrowers to raise money more efficiently. By borrowing in markets where they can obtain the cheapest funding, and entering into a swap to exchange interest payments into another currency or interest rate basis, liabilities can be transformed to reflect better the asset mix of the business, at an economic advantage over directly raising money in that currency or interest rate format. Equally, asset managers can use swaps to transform individual lines of paper, or the key characteristics of the fixed income portfolio, to improve return or reduce risk.
Despite their longevity, interest rate instruments are still the fastest growing sector of the derivatives market. Recent figures released by the Bank for International Settlements (BIS) show an increase in outstanding contracts of 15% in the second half of 2001 to $78trn (e83trn – see figure 1). The most significant increase was in interest rate swaps with $59trn outstanding, by far the largest product group in the $111trn OTC derivatives market. Of this figure some $19trn is denominated in dollars, a rise of 19% on the half year, with the decline in interest rates post-11 September provoking a spurt of hedging activity among new market participants such as mortgage banks and MBS investors. There was an 18% rise in euro-denominated swaps to $21trn, a resumption of growth after flatter conditions in 2000.
Whereas initially swaps might have been struck directly between commercial companies, with the saving each made on financing via the swap split between the two, nowadays companies and investors transact with a swap market-maker, with the rates quoted reflecting the overall balance of supply and demand for fixed versus floating rate paper. The credit risk of a swap can be seen as equivalent to a double-A rated bank, as these make up the composition of Libor fixing panels. Swaps transactions are normally covered by International Swaps and Derivatives Association (Isda) agreements between the counterparties and trade confirmations rely on standard Isda terms and conditions. Swaps pricing screens quote a given fixed rate for each tenor of swap against a floating rate reference rate, such as Libor. The fixed rate leg of the swap could be viewed as a prediction of the average expected Libor rate over the life of the swap. The fixed rate is normally expressed as a spread to a benchmark government bond, in market parlance the swap spread. So, in theory the swap spread reflects market expectations of the average differential between Libor and the government curve repo over the life of the swap.
The interest rate swap market is very large and liquid, with bid-offer prices typically 1 basis point on sizes of $50m–100m notional in G3 currencies. Increasing market standardisation means that although swaps are struck between two counterparties, a contract may be closed out with another counterparty by assigning the original contract to the new counterparty. This means that end-users of swaps can deal at the best price for closing the swap.
Swap spreads are derived by market forces and are influenced by the willingness of borrowers to issue at fixed rates versus the appetite of investors for fixed-rate paper. When interest rates are high, swaps spreads tighten, because few borrowers wish to lock in to high rates of interest, and those that do will want to swap. The imbalance between the appetite of fixed- rate receivers and fixed-rate payers creates downwards pressure on the fixed side of the spread. Correspondingly, spreads widen when rates are low, because of the flood of borrowers keen to lock in low rates, versus the limited appetite of investors for low-yielding fixed-rate paper. Since 1999 there has been increasing volatility in swap spreads and additional performance could have been obtained from swapping out of bonds and back again over this period.
Research by JP Morgan has found that the key drivers of movements in swap spreads are the shape of the yield curve, budget expectations and risk aversion. Market segmentation at the long and the short end of the yield curve means that swap spreads widen when the yield curve is flat or inverted. Issuers will swap long end interest payments for shorter-dated maturity liabilities when the yield curve is steep and this causes swap spreads to tighten. JP Morgan found that a 10bps steepening in the yield curve (for example, the differential between two-year and 10- year yields on government paper) led to a tightening of 2bps in the swap spread. The supply of government bonds will influence swap spreads, because the swap spread reflects the relative supply/demand for government bonds versus swaps, with an increase in supply expectations tightening swap spreads. Corporate bond issuance is less of a driver, because companies are more opportunistic in their funding patterns. Fluctuations in investor risk appetite are also a driver of swap spreads, as risk aversion creates a flight to quality into government bonds and widens swap spreads. As investors move into higher-yielding, less liquid assets, swap spreads tighten. Hence market liquidity is a driver, since it influences the actions of investors.
The simplest and most common way to use swaps is to synthesise a floating-rate note by buying fixed paper and entering a swap to receive floating on payment of fixed-rate cashflows. The total package will have little sensitivity to movements in absolute yields or the yield curve. Money market funds that offer a Libor-based return are the natural users of this structure, although differences in accounting treatment between underlying cash instruments and interest rate hedges in most European countries create problems in reporting the overall yield. These products are, however, widely used in France, where both swap and cash instruments can be treated on an accrual basis, and cashflows from the swap are matched against interest income on the cash product. French money market funds and short bond funds through buying fixed rate instruments and swapping against a euro bid reference rate, can achieve higher and more consistent returns, by not having to buy volatile short-term instruments.
Isabelle Reux-Brown, bond fund manager at CDC-Ixis Asset Management in Paris, which has approximately E26bn of money market funds under management, elaborates: “Money market funds can buy commercial paper and Treasury bills of up to 15 months duration and swap the quarterly interest payments to receive Eonia, the euro overnight interest rate average. The synthetic asset created by a swap on a longer duration asset is valued as an asset in its own right. Often if we are buying fixed rate ABCP asset-backed commercial_paper we will swap interest rate payments directly with the ABCP sponsor. A money market fund restricted to buying high-grade floating-rate paper will typically yield 5–10bps below Eonia. By swapping and buying slightly lower rated paper a fund can achieve 15bps over Eonia.”
Swap indices are available which reflect the economic performance of swap markets. Exposure to one of the family of Total Return Swap Indices (TRSIs) offered by JP Morgan can be obtained either via a swap or by buying a bond linked to the index. TRSIs are available on euro, US dollar, yen, British pounds and Swiss francs for three-year, five-year, seven-year and long bond tenors. With declining government issuance, some suggest that TRSIs should replace government bond indices as benchmarks for fixed income investors. Paul Grainger, bond fund manager at Gartmore, which runs £9bn (e14bn) of fixed income funds out of London, comments “this is a well-worn theme that resurfaces whenever liquidity or issuance falls. In my view, swap indices are useful for benchmarking portfolios composed mainly of corporate paper, or funds with a Libor target, but not funds investing mainly in government paper”.
The daily price of the TRSI is calculated by reference to daily swap price fixings published by Isda on Reuters. TRSIs offer constant maturity and stable duration, whereas bond indices fluctuate on these measures due to variable issuance patterns and inclusion rules. TRSIs can be used to generate an instrument that is tailored to the investor’s liabilities and are less susceptible to squeezes in certain areas of the yield curve. TRSIs offer the investor the ability to take a credit position, since their returns reflect the credit risk of the highly rated banks from which swap prices are obtained. Index levels for the JP Morgan and Lehman swap indices are published on bank websites, Reuters and Bloomberg screens.
Pension funds and asset managers running pension fund money may be prevented from using interest rate swaps by blanket bans on the use of derivatives. This is particularly an issue for comingled funds, since all investors in the fund must buy into using derivatives in order that they can be used at all. Even where derivatives are allowed, there is additional administration involved in the regular payments under the swap, and, if swap exposures are covered by cross-collateralisation, there may be daily postings of collateral to deal with. Counterparty risk can be minimised by netting arrangements so that opposing cashflows on different contracts with the same counterparty can be offset against each other.
Exchange-traded swaps now exist in the form of the Liffe Swapnote on the euro swap curve, settling on two-year, five-year and 10-year swap rates, and a US dollar product issued by the Chicago Board Options Exchange. Dealers report that spreads are wide, at two to three ticks and volumes light. Liffe comments that four ticks is equivalent to a spread of 0.5bps of yield on a 10-year contract. Most trades are basis trades, where the future is being traded against the purchase or sale of a cash instrument. The two-year product is the most transparent, with four market-makers, whereas only two firms make markets in the five-year and 10- year product. The maximum open interest recorded in all Swapnote products was 228,850 contracts on 17 December 2001. This is equivalent to a notional amount of E22.8bn. The BIS survey reports a total of $21.6trn notional of outstanding contracts at end-2001. A spokesman for Liffe commented that a higher than average proportion of asset managers are involved than is usual for a new product, because the product is more transparent than the traditional swap market and there is almost no counterparty risk.
Fund rules on cover for derivative transactions and efficient portfolio management can make the use of swaps problematic and sometimes completely inefficient. Paul Dentskevich, senior quantitative analyst at Threadneedle, which runs £15bn of fixed income funds out of London, comments “fund rules can require full coverage of any derivatives transaction to restrict leverage and speculation which in turn limits the viability of these products. For instance, an OEIC cannot sell more fixed-rate exposure than it actually owns, and it must have cash in hand to cover the floating-rate leg of the swap, as if it were transacting for physical delivery. Once a transaction is in place, the cover required is also tied up for the duration of the swap”.
Swaps can be used for duration management and to make up for any lack of government paper at appropriate points of the curve. Swaps are available at every point of the curve up to 30 years, and by buying a long-dated fixed-rate leg against paying floating, one can extend the duration of the portfolio as desired. This could be seen as analogous to taking money out of cash to buy long-dated paper, or funding a purchase on long-dated paper by borrowing.
By buying and selling swaps against each other, a fund manager can take a view on movements in the shape of the yield curve, without disturbing the underlying portfolio. A topical trade at present is to exploit the UK’s possible entry into the euro, which will depress rates at the long end. By entering a swap to pay 30-year fixed and receive Libor, while simultaneously swapping to receive 10-year fixed and pay Libor, the Libor legs cancel out, and this becomes a straight play on the differential between 10-year and 30-year fixed rates, if one assumes no change in the swap spread.
A yet more complex strategy would be to take a view on the credit spreads of double-A rated credits by selling a swap against a purchase of long gilt futures.
Swaps have a role in providing protection against falling annuity rates to corporate providers of pension products. As Rob Standing, head of JP Morgan’s European rates business, relates, “institutions that have offered products with guaranteed annuity rates have been buying longer-dated swaptions to insure themselves against lower rates”. A swaption is where one party grants the other the option to pay fixed on a forward starting swap.
Funds that are not permitted to directly transact swaps may gain the same effect by buying the product within a structured note. In the US where the yield curve is flat, notes have been sold that contain embedded written options on forward rates to generate additional income. Structures to provide higher yield at the expense of principal protection are still popular in Europe, despite extensive losses suffered by some buyers of geared products in 1994 when rates suddenly rose.