Intermarket Spread Swap

What Is Intermarket Spread Swap?

An intermarket spread swap is an exchange, or sale, of one bond for another with different terms, such as a different coupon rate, credit rating, or maturity date, to capitalize on yield discrepancies between bond sectors.

Understanding Intermarket Spread Swap

An intermarket spread swap can help produce a more favorable yield spread for the investor. A yield spread is a difference between yields on various debt securities with varying maturities, credit rating, and risk. In other words, one fixed-income security is sold or swapped for another security that is viewed as being superior in some way.

By entering an intermarket spread 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 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 instrument. For example, if one type of bond has historically seen a 2% return rate, but the yield spread reveals a 3% difference, the investor might consider “swapping,” or essentially selling, the bond to try to narrow the difference and earn a higher profit.

Intermarket Spread Swap Limitations

One important consideration of an intermarket spread swap is for the investor to consider what is driving the difference in the yield spread. Typically, bond yields tend to rise when their prices fall, but a smart investor will also take into consideration just what is causing those prices to drop.

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 junk bonds is a decision that should not be taken lightly by investors.