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The Irresistible Rise of U.S. Dollar Swap Spreads

By Simon Boughey

Dealers have been moaning about the decline of spreads in the U.S. dollar swaps market for years. The swap spread is the differential between the swap rate and the underlying Treasury yield. When spreads are thinner, it becomes less attractive to swap from fixed-rate debt into floating rate.

Last year, two-year swap spreads, quoted at the midmarket, were 29.5 basis points. In late August, they skyrocketed to 89 basis points. Spreads have now widened by nearly 300 percent across the curve, with 10-year spreads reaching their widest levels since the beginning of the decade.

There are a number of reasons for this remarkable explosion in spreads. “I think it's just everything,” said Ying Lee, U.S. dollar trader at ABN Amro in Chicago. On one level, it is natural for swap spreads to have risen sharply, since they are essentially credit spreads and thus should reflect the ongoing worries about Asian economies and the recently plummeting U.S. stock market. Indeed, U.S. dollar swap spreads spiked up to close to 55 basis points at 10-year in the immediate wake of the Asian flu last October.

But there are other, more technical reasons. The most important of these is the scarcity of Treasury securities and the consequent tightness of borrowing rates in the repo market. Treasuries are scarce because fewer are being sold as the U.S. government cuts its deficit. On May 6, the Treasury Department announced that the five-year note auction would move from a monthly to a quarterly cycle and that the three-year note would be abolished. Both these developments restricted the number of three and five-year notes in circulation.

U.S. dollar swap spreads have risen dramatically in recent months in the wake of deciding budget deficits.

The paucity of Treasury securities, in turn, reduces borrowing rates in the repo market. A payer of fixed rate in the swaps market hedges the position by lending the note in repo and borrowing cash against that collateral. When borrowing rates are low, the payer is able to derive positive carry from the difference between the rate being paid for the cash and that of general collateral. This, in turn, allows swap bids to become more aggressive.

When repo rates drop below general collateral, the note is said to be “on special.” Recently, 10-year notes have changed hands in repo for as little as 1 percent or 2 percent, while 30-year bonds have been at or below 1 percent, giving the payer of fixed an easy way to make money from the positive carry. “The frequency with which notes go on special has increased dramatically in this environment,” notes one market analyst.

The situation has been exacerbated by the flight to quality in the Treasury market as the stock market has faltered. The Treasuries are in high demand, and those who have them aren't keen to let go. This problem has been particularly acute at the short end of the curve. Spreads there widened sharply at the end of July and the beginning of August as the Dow Jones Industrial Average tumbled and investors dived into short-dated notes.

Spreads have widened by nearly 300 percent across the curve, with 10-year spreads reaching the widest levels since the beginning of the decade.

The widening of credit spreads, particularly in the emerging market sector, has also allowed asset swap targets to be hit. Asset swaps involve paying fixed rate against a security to give the holder of that security a synthetic floating-rate asset yielding an attractive margin above Libor. Thus, the holder of a five-year bond paying 300 basis points over the five-year note could asset-swap the security to floating rate at close to Libor plus 250 basis points. The increase in asset swap business has led more payers into the swaps market.

Unfortunately for swaps dealers, the widening of spreads has not resulted in a bonanza of new issues. For one thing, rates are so low that U.S. issuers, never keen swappers anyway, see no reason not to take fixed rate. For another, secondary market spreads have often moved out as far or even beyond swap spreads, reducing possible arbitrage opportunities.

“It is very much a lopsided market,” concludes Tim Prister, vice president of fixed income at General Re Financial Products. Nothing is expected to happen until September, when people returning from vacations and the traditional rush to borrow debt could bring spreads down.

ISDA Publishes EMU Protocol

The International Swaps and Derivatives Association, in keeping with its role as the world's derivatives rule-maker, published in June a series of annexes to its master agreements that it calls its EMU Protocol. By late July, more than 100 firms had signed on, meaning that they agree to some or all of the Protocol's annexes.

“The EMU protocol was created to address some of the issues that have been identified in the derivatives world that will arise out of EMU and its effect on derivative contracts,” says Robert Pickel, general counsel at ISDA. “It is a new and unique format that allows parties on a multilateral basis to amend their existing ISDA master agreements.” ISDA master agreements establish certain multilateral rules that apply to all signatories, eliminating the need to include all of the provisions in each contract.

The procedure for joining the EMU Protocol is relatively simple. A party to an ISDA master agreement sends ISDA a letter indicating that it agrees to the protocol and identifying which of the five annexes it wishes to be applied to all of its outstanding ISDA master agreements. If Company A indicates, for instance, that it agrees to all five of the annexes, while Company B says it agrees to four of the five, then a contract between the two would be bound by the four annexes they have in common.

The annexes deal with the following issues: continuity of contracts after EMU; various price source matters; payment netting; definitions of euro, European currency unit, ecu settlement day, business day, and banking day; and bond options, including the provision that bonds denominated in national currency units may be redenominated in euros.

If you're not among the 100-plus firms that have already signed on, you'd better hurry. ISDA has set a September 30 deadline for participation in the EMU Protocol.

For more information on the EMU protocol, including the full text of the document, a sample letter and a list of participating firms, see www.isda.org.

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