What Is a Spreadlock?
A spreadlock is a credit derivative contract that establishes a predetermined spread for future interest rate swaps. The two main types of spreadlocks that can be used are forward-based spreadlocks and option-based spreadlocks.
With a spreadlock, an interest rate swap user may lock in a current spread between a swap and an underlying government bond yield. This strategy allows for the transfer of basis points forward to the time when the swap is written.
Spreadlocks are potentially useful for investors contemplating the use of an interest rate swap at some point in the future. However, they are not available in all markets.
- A spreadlock is a credit derivative that sets a predetermined spread for future interest rate swaps.
- A spreadlock allows an investor or trader to lock in a current spread between a swap and an underlying government bond yield.
- The two types of spreadlocks are forward-based spreadlocks and option-based spreadlocks.
- A forward spreadlock allows for a definitive increase of a set number of basis points on top of the current spread.
- The buyer of an option spreadlock can decide whether or not to utilize an interest rate swap.
- A spreadlock’s price is equivalent to the difference between the implied forward swap rate and the implied forward bond yield.
- Spreadlocks allow for more precise interest rate management plus increased flexibility and customization of interest rate swaps. They are often used to hedge bond issuances.
Understanding a Spreadlock
Spreadlocks have been an option for investors since the late 1980s, and they quickly joined swaps, caps, floors, and swaptions as plain vanilla derivative structures.
A forward spreadlock allows for a definitive increase of a set number of basis points on top of the current spread in the underlying swap. With a spreadlock through an option contract, the buyer of the contract can decide whether or not to make the swap useful.
An example of a forward-based spreadlock would be a two-way contract in which the parties agree that in one year’s time they will enter into a five-year swap. In this hypothetical swap, one party will pay a floating rate, such as the London Interbank Offered Rate (LIBOR), and the other party will pay the five-year Treasury yield as of the start date, plus 30 basis points. In the case of an option-based spreadlock, one of the parties would have the right to decide whether or not the swap will go into effect before the date of maturity.
Spreadlocks can be regarded as credit derivatives since one of the factors driving the underlying swap spread is the general level of credit spreads.
Some advantages of using a spreadlock are that they allow for more precise interest rate management, plus increased flexibility and customization. The main goal of a spreadlock is to hedge against adverse moves in the spread between swaps and the underlying government bond yield.
Some disadvantages are that spreadlocks require documentation from the International Swaps and Derivatives Association (ISDA), have unlimited loss potential, and because implied forwards can sometimes be unattractive.
Spreadlocks and Swap Spread Curves
A spreadlock’s price is equivalent to the difference between the implied forward swap rate and the implied forward bond yield. The swap spread curve can be viewed independently from the overall swap yield curve.
As is the case with all implied forwards, a positively sloped spread curve suggests that swap spreads will rise over time because swap spreads for shorter maturities are lower than longer maturities. A negatively sloped spread curve means that swap spreads will fall over time because swap spreads for shorter maturities are higher than longer maturities.
Spreadlocks and Hedging Bond Issuances
Spreadlocks are primarily used to hedge bond issuances. When a company issues a bond the fixed rate is usually above that of the Treasuries. When a company is issuing a bond, the interest rates can change between the time of the decision to issue a bond and the time of funding.
It can be difficult to hedge the changes in the spread between the offered fixed-rate and the yield on the Treasury. Using a spreadlock locks in a swap rate for a specific period of time at a specific amount in advance, regardless of what the rates are at the time the swap begins.