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term structure models mentioned below that 30-year
spread dynamics have been incorporated with some
success into the standard framework.
One of the drawbacks to linear regression models is
that they can’t capture any tendency for the influence
of the factors to vary over time or operate across
different horizons. For example, the effect of corporate
issuance on swap spreads acts as a rather short-term
effect – e.g. the swapping of a fixed rate issue to
floating exerts tightening pressure on spreads on the
day the issue is swapped. Corporate issuance also
tends to exhibit seasonal patterns, as evidenced in
Chart 3. A pick-up in Treasury supply tends to be a
more fundamental economic signal, and its “normal”
tightening bias on swap spreads has been shown to
act over longer periods of time.
Of course the current economic environment has
turned many of these “normal” factors on their heads.
The enormous amount of Treasury supply hasn’t
appeared to exert much pressure on front end
spreads, and the impact of convexity hedging of
mortgage portfolios – which used to be a dominant
factor correlating 5y and 10y swap spreads to the level
of rates – has dropped off dramatically.
Swap spread term structure models
These changes in the economic environment and
clear alterations in the strength of various correlations
have increased the use of full blown term structure
models to analyse the term structure of swap spreads.
These stochastic models attempt to capture the
variability of economic factors, curve and volatilities on
swap spreads over time.
An excellent example of this approach is detailed in
the December 2008 paper, “Modeling Swap Spreads
in Normal and Stressed Environments”, by Vineer
Bhansali, Yonathan Schwarzkopf and Mark Wise.
Although a complete synopsis of this paper and their
approach is beyond the scope of this article, it is worth
repeating several of the conclusions.
“...a robust model of swap spreads... should capture the key factors
we know that describe the movement of swap spreads. These
factors include the level and shape of the sovereign yield curves, the
relative supply of risky to riskless debt, the activity of mortgage
hedgers (convexity hedging), and the movements in credit spreads.
(pg 2)
It has been shown that one of the drivers of the swap spread is the
slope of the yield curve. [The] value of the 10 year swap spread was
regressed versus the yield curve slope for data spanning January
1997 to August 2003. As the slope of the yield curve the author used
the difference between the 10 year and 2 year rates and the linear
regression coefficient was calculated to be −0.19. The negative
value of the coefficient implies that the swap spread tightens as the
curve steepens. This coincides with the intuition that as the yield
curve steepens market players prefer to be the fixed-rate receiver in
a swap and commercial banks will be less inclined to hedge their
short term variable rate deposits reducing the demand to be a fixed
rate payer. This will reduce the demand for swaps and as a result
will decrease the swap rates and tighten the spread...
Interestingly, the negative dependence of the swap spread on the
slope of the yield curve breaks down around the summer of 2007...
Starting at around June 2007 the swap spread widens as the slope
of the yield curve steepens. ... This behavior seems to be associated
with a breaking of the usual dependence of the swap spread on the
slope of the yield curve.”
Corporate issuance and swap spreads
As the paper points out and the markets have
experienced, swap spreads traversed a period, and
may still be in it, where the slope of the curve is not a
dominant driver. Our experience over the past year,
since the paper was published, also points to the
diminishing effect of mortgage hedging activity and
Treasury supply on spreads.
So what’s left? Clearly the liquidity premium – which in
some sense can become a “catch all” factor – appears
to be dominating front end spread dynamics.
Historically corporate issuance was a second-order
influence on spreads. Now that corporate issuance
patterns appear to be normalizing somewhat from the
event-driven patterns of 2008 and 2009, it’s possible
that the supply of risky debt may become more
influential on spreads.
Although we expect only a moderate pick-up in high
grade issuance as we exit the summer doldrums, we
think this might have a more concentrated than normal
tightening effect on swap spreads – particularly in the
front end – given the absence of influence from the
other “normal” drivers.
Chart 3: US High Grade Corporate Issuance (monthly, since 2005)
Amount (in billions)
180
160
140
120
100
80
60
~30% in Jan09 FDIC gtd
~20% FDIC gtd
~36% FDIC gtd
2005
2006
2007
2008
2009
2010
Lehman failed Sept 08
~100b (86%) of Dec 08
issuance w as FDIC guaranteed
40
20
-
JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC
Source: Informa Global Markets, FDIC, BNP Paribas
Mary Beth Fisher 16 July 2010
Market Mover, Non-Objective Research Section
25
www.GlobalMarkets.bnpparibas.com