What is Intermarket Spread Swap
An Intermarket spread swap is the exchange of two bonds within different parts of the same market that can help produce a more favorable yield spread. A yield spread is a difference between yields on various debt securities with varying maturities, credit rating, and risk. One bond is sold to purchase, or swap, for another security seen as superior in some aspect.
An Intermarket spread swap is a transaction meant to capitalize on a yield discrepancy between bond market sectors.
BREAKING DOWN Intermarket Spread Swap
Intermarket spread swaps have a basis on the yield spreads between different bond sectors. By entering a swap, parties gain exposure to the underlying bonds, without having to hold the securities directly. An Intermarket spread swap is also a strategy to attempt to improve an investor’s position through diversification.
Opportunities for Intermarket spread swaps exist when there are credit quality, or feature differences, between bonds. For example, investors would swap government securities for corporate securities if there is a wide credit spread between the two investments and the spread is expected to narrow. One party would pay the yield on corporate bonds while the other will pay the treasury rate plus the initial range. As the spread widens or narrows, the parties will begin to gain or lose on the swap.
An example of an Intermarket Spread Swap could occur in a situation when the investment rate of return on a bond changes, so the investor “swaps” it out for the better-performing kind. For example, if a one type bond has historically seen a 2 percent return rate, but the yield spread reveals a 3 percent difference, the investor might consider “swapping,” or essentially selling, the bond to try to narrow the difference and yield a higher profit.
Limitations of an Intermarket Spread Swap
One important consideration of an intermarket spread swap is for the investor to consider what is the driving the difference in the yield spread. Typically, bonds yields tend to rise when their prices fall, but a smart investor will also take into consideration just what is driving those dropping prices. For example, during times of recession, a wide yield spread could actually represent the perceived higher risk of that bond instead of just some bargain pricing. Purchasing what actually boils down to high risk bonds is a decision that should not be taken lightly by investors.