Commercial mortgage broker Financial Compound is please to present here the culmination of three years of its research into swap spreads. Swaps spreads are a measure of risk in the credit markets. The higher the swap spread, the bigger the credit risk in the market as perceived by market players. Its easier to understand how swap spreads are a proxy for risk if we start with a relatively simple example of how to gauge credit risk in the market. Credit risk can generally be viewed as the difference between the 90 day T-bill and the 90 day libor. The t bill is considered to be the risk free rate. Libor is the bank overnight borrowing rate, and has credit risk built into it- the risk that the bank will not repay the overnight loan to the other bank who lent the money. If one looks at the spread between these rates, it has run around 50 basis points historically. It got up over 100 bps during the 1987 stock market crash, the Long Term Capital market crash in 1998, and the subprime credit crunch in 2007. Many Commercial Mortgage Lenders use swap rates and swap spreads to price their commercial mortgage products.
Now lets turn back to swap spreads. The 10 year swap spread is the difference between the 10 year swap rate and the 10 year Treasury. And the 10 year swap rate is the fixed rate on a Libor-based interest rate swap. For example, if the 10 year treasury was 4.0% and the 10 year swap rate was 5.0%, then the 10 year swap spread is 100 basis points. The 10 year treasury is considered the risk free rate. The 10 year swap rate includes a premium for the credit risk that the swap counterparty will not make its payments. Historically the swap spread has ranged around 55 basis points. At the height of credit crunches it has gotten up to around 125 bps.
The swap rate is what the swap market charges someone to swap from floating to fixed rate. The fixed swap rate is swapped with a 90 day or 180 day libor floating rate, and is called a vanilla interest rate swap. The swap market has a lot of liquidity. Therefore the swap spread can also be understood as the market’s understanding of expected future libor rates. When swap spreads go up, it tells us that the market thinks libor rates are going up. However, swap rates are also determined by supply and demand factors (i.e. the supply and demand in the market to borrow funds) as well as numerous other market conditions.
Furthermore, recently with the financial crises in 2011 the market has panicked and investors shy away from credit spread products and had a flight to liquidity. Many investors are keeping their money on deposit at the banks. So banks don’t need to borrower overnight and some economists argue that libor, and swap spreads are artificially low as a result because the low rate is a product of the low demand for this overnight borrowing. So that if we rely on swap spreads to determine risk based yields, we may be fooling ourselves. Some market observers have looked to other types of spreads to gauge the credit risk in the markets. In a 7/15/2011 Wall Street Journal article called “Key Credit Guage Loses Clout” Gary Jenkins, head of fixed-income research at Evolution Securities in London prefers to track the spread between the 10 year Treasury, and the 10 year debt sold by Greece, Portugal, and Spain to guage credit risk than swap spreads in the current environment.