Swap rates fall below Treasury yields

A historic relationship between US government bonds and interest rate swaps has broken down this week, for only the second time, as a flood of corporate debt issuance from banks pushed 10-year swap rates below Treasury yields.

The negative spread between swaps and "risk free" Treasuries occurred for the first time in March and that inversion only abated at the end of April.

This week the relationship between government bonds and swaps has dislocated again, largely as a result of the burst of bond issuance from banks. Some $7.2bn in new debt has been sold that was mainly swapped from fixed to floating rates of interest.

This increase in swap trading has coincided with growing optimism that the worst of the eurozone crisis may now have passed. Those hopes, combined with a solid start to the earnings season, has triggered a strong rally in financial stocks.

Swapping debt deals to much lower floating rates or three-month Libor, the interbank borrowing rate, tends to narrow the relationship between fixed long term swap rates and Treasury yields.

"Recent corporate issuance and the decline in Libor has driven swap spreads tighter over Treasury yields," said Michael Chang, strategist at Credit Suisse.

The scale of dislocation in the interest rate swaps market has caught out some investors and traders. There was speculation on Thursday that at least one hedge fund, specialising in macroeconomic trading strategies, could have suffered large losses.

Combined with less liquid summer trading conditions, the drop in swap rates and Libor has forced investors to cut their losses.

These "stop loss" flows, swap traders said, had exacerbated the inversion between swaps and Treasury yields this week.

On Friday morning, the 10-year swap rate was trading at 2.90 per cent, versus a 10-year yield of 2.93 per cent. The swap rate turned negative on Tuesday.

Back in March, the swap rate traded as much as 10 basis points below that of the Treasury yield.

Tighter swap rates relative to Treasury yields could well be a feature of US fixed income markets for some time, analysts said. High government bond supply narrows the relationship between Treasury yields and swap rates.

"The supply landscape between Treasury issuance and private borrowing should keep swap spreads structurally tight," said Mr Chang.

US banks, meanwhile, have some $98bn of government-backed debt maturing next year, with a further $200bn rolling off the books in 2012.

That debt will probably be replaced by bank issuance targeting the five- and 10-year sector. Analysts said subsequent swapping activity and continued heavy issuance of Treasury debt should keep swaps at narrow levels over bond yields.

"In the coming years we expect the belly of the curve to see a much higher share of issuance, causing corporate issuance to have a larger impact on five-year to 10-year swap spreads," says Michael Cloherty, head of US rates strategy at RBC Capital Markets.

Also playing a role in the latest inversion has been continued demand by investors for using swaps to satisfy long-dated liabilities rather than committing their capital to buying bonds.

This has remained a key theme since the financial crisis.

The 30-year swap rate currently sits 31.5bp below 30-year bond yields and this part of the swap curve has been inverted to Treasuries since the demise of Lehman Brothers nearly two years ago.

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