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By Rom Badilla, CFA – BondSquawk:

Many people including mainstream media are scratching their heads on today’s action as the yield on 10-year interest rate swaps traded well below the yield on 10-year U.S. Treasuries.

Theoretically, such a dynamic should not happen since Treasuries are backed by the safest creditor in the world while entering into an interest rate swap agreement subjects an investor to credit risk stemming from the counterparty, such as a bank or financial entity. Such risk should command incremental return to the investor in the form of higher yield and thus a positive spread between the riskier swap and the risk free Treasury. This was not the case as the spread entered into negative territory for the first time in recent history.

There are three catalysts that point to this event with the first being the Federal Reserve’s latest policy statement suggesting that short term interest rates will remain low and accommodative for the foreseeable future. Essentially, the Fed will keep the Fed Funds rate at current levels until improvement in the country’s unemployment rate and as long as inflation remains subdued. The second is the waning demand for U.S. Treasuries as evident by today’s auction and increasing risk for sovereign debt such as Greece and Portugal, which was downgraded by Moody’s today to AA-. Each fact points to higher yields. The third catalyst is the impending amount of corporate debt issuance.

The best way to illustrate this is to analyze it is from the perspective of a corporation that is looking to issue debt and minimize the subsequent interest expense. This can be done particularly in this rate environment by issuing out floating rate debt, which closely tracks short-term rates like the Fed Funds rate. Since the Fed Funds rate should remain low and anchored due to the aforementioned reasons, this is ideal for a corporation. However, investors who are trying to maximize returns prefer to receive a higher set or fixed coupon that will closely resemble the 10-year note (plus credit spread commensurate with the corporation).

In order to bridge this gap of needs, a corporation will cater to investors by issuing debt with a higher fixed coupon. Unfortunately, with longer maturity yields tracking higher due to the aforementioned reasons of the weak Treasury auction and the increasing sovereign risk, this is far from ideal for the corporation. This can be circumvented by entering into an interest rate swap agreement with a counterparty, such as a bank.

The swap agreement will allow the corporation to receive a fixed rate from the bank, which will offset the fixed rate amount paid to investors on the debt, in exchange for paying a floating rate to the bank. In essence, by entering into a swap agreement, a corporation is able to reach its goal of issuing debt and minimizing interest expense.

So going back to today’s environment where on the horizon, large amounts of corporate debt issuance is hitting the market with not enough counterparties to offer swap agreements, the price increases (in the form of declining yield on the interest rate swap) due to higher demand and insufficient supply. This market imbalance is the reason why swap spreads on the longer end of the curve turned negative and counter to market theory.

While it is difficult to gauge how long this imbalance will persist, I do think that 10-year swap spreads will revert to its proper relationship. I think that if the corporate calendar finds a respite and if market volatility spikes (VIX jumped 7.3 percent today) due increasing sovereign risk, equity weakness, mounting Treasury supply, or some combination, swap spreads could widen back into positive territory where it belongs.

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