What to do with a Negative Swap Spread

From a recent article of mine, this is what I was asked, and how I responded:

  1. matt Says:
    Mr. Merkel:

    I think that I saw somewhere (recently) that swap spreads on the long end were negative. I assume (correct me if I’m wrong) that this is the spread over treasuries. How is this possible? What does/did it mean?

    PS: Good luck to all of the CFA candidates who took there exams today?

  2. David Merkel Says:
    I was taught way back when that it should be impossible. I was taught that it was impossible for the swap curve to invert, but it did it at the end of the last tightening cycle.

    John Jansen has written about this, and others have commented at his excellent blog on this topic. This is my take: there are many who want to receive fixed, and pay floating for a long time. This depresses the 30-year swap yield.

    Some want to do so because they are hedging exotic instruments that do the opposite, others because they might be hedging long term guarantees for long-dated liabilities (pensions, etc.), looking to minimize losses synthetically.

    I’m not sure anyone has the definitive answer. But here’s a game to play. Swap rates reflect AA counterparties. Take a 30-year Treasury. Pay fixed on the swap, receive back 3-month LIBOR. The package now pays 20 bp over 3-month LIBOR. Put it in a trust, get Moody’s and S&P to rate it, and call it “The Floating Rate Treasury Trust.” Sell participations to money market funds. This beats three-month T-bills by a little less than 60 basis points before expenses.

    Now, I wouldn’t buy that if I were managing a money market fund just because of the illiquidity versus Treasuries. But there is a tweak we could try:

    On top of the trust, offer protection on a basket of 100 single-A names on a five year rolling basis. Now the yield really swings; negotiate terms with the rating agencies so that it can be rated A1/P1/F1.  The excess yield is worth the illiquidity.


Okay, 30-year swap yields have been less than Treasuries for some time.  I’m not totally certain as to why.  There are a lot of games going on in the derivatives markets, and they seem to favor buying long and financing short.  I do know that there are gains to be made in the short run from taking the opposite position, unusual as that is… but as with any anomaly in the market, be cautious, because the motives of other players shift, making opportunities more attractive, less attractive, or unattractive.