Swap Spread: Definition, Use as an Indicator, and Example

What Is a Swap Spread?

A swap spread is the difference between the fixed component of a given swap and the yield on a sovereign debt security with a similar maturity. In the U.S, the latter would be a U.S. Treasury security. Swaps themselves are derivative contracts to exchange fixed interest payments for floating rate payments.

Because a Treasury bond (T-bond) is often used as a benchmark and its rate is considered to be default risk-free, the swap spread on a given contract is determined by the perceived risk of the parties engaging in the swap. As perceived risk increases, so does the swap spread. In this way, swap spreads can be used to assess the creditworthiness of participating parties.

How a Swap Spread Works

Swaps are contracts that allow people to manage their risk in which two parties agree to exchange cash flows between a fixed and a floating rate holding. Generally speaking, the party that receives the fixed rate flows on the swap increases their risk that rates will rise.

At the same time, if rates fall, there is the risk that the original owner of the fixed rate flows will renege on a promise to pay that fixed rate. To compensate for these risks, the receiver of the fixed rate requires a fee on top of the fixed rate flows. This is the swap spread.

Swap spreads correlate closely with credit spreads as they reflect the perceived risk that swap counterparties will fail to make their payments. Swap spreads are used by large corporations and governments to fund their operations. Typically, private entities pay more or have positive swap spreads as compared to the US government.

Swap Spreads as an Economic Indicator

In the aggregate, supply and demand factors take over. Swap spreads are essentially an indicator of the desire to hedge risk, the cost of that hedge, and the overall liquidity of the market.

The more people who want to swap out of their risk exposures, the more they must be willing to pay to induce others to accept that risk. Therefore, larger swap spreads means there is a higher general level of risk aversion in the marketplace. It is also a gauge of systemic risk.

When there is a swell of desire to reduce risk, spreads widen excessively. It is also a sign that liquidity is greatly reduced as was the case during the financial crisis of 2008.

Negative Swap Spreads

The swap spreads on 30-year swap T-bonds turned negative in 2008 and have remained in negative territory since. The spread on 10-year T-bonds also fell into negative territory in late 2015 after the Chinese government sold US treasuries to loosen restrictions on reserve ratios for its domestic banks.

The negative rates seem to suggest that markets view government bonds as risky assets due to the bailouts of private banks and the T-bond selloffs that occurred in the aftermath of 2008. But that reasoning does not explain the enduring popularity of other T-bonds of shorter duration, such as the two-year T-bonds.

Another explanation for the 30-year negative rate is that traders have reduced their holdings of long-term interest rate assets and, therefore, require less compensation for exposure to fixed-term swap rates.

Still, other research indicates that the cost of entering a trade to widen swap spreads has increased significantly since the financial crisis due to regulations. The return on equity (ROE) has consequently decreased. The result is a decrease in the number of participants willing to enter such transactions.

Example of a Swap Spread

If a 10-year swap has a fixed rate of 4% and a 10-year Treasury note (T-note) with the same maturity date has a fixed rate of 3%, the swap spread would be 1% or 100 basis points: 4% - 3% = 1%.