DERIVATIVE PRODUCTS GROUP

WHY ARE SWAP RATES TRADING

BELOW U.S. TREASURY RATES?
WHAT’S THE OPPORTUNITY FOR YOU?
Tina Hwang, Managing Director, PNC’s Derivative Products Group
Vickie DeTorre, Managing Director, PNC’s Derivative Products Group

Historically, interest rate swap (swap) rates1 have been higher than the essentially
risk-free U.S. Treasury securities (Treasuries) of the same maturity. The difference
between the two rates is known as the swap spread. Swap spreads represent the
incremental funding cost for financial institutions, and more broadly represent the credit
spread over the corresponding benchmark U.S. Treasury for interbank lending.

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 Current negative swap spreads
present an opportunity for
market participants favoring
fixed rate debt.
The regulatory
requirement for central
clearing of most interest
rate swaps (except for
swaps with commercial
end users) has removed
counterparty risk from
swap contracts.
2
Historically, swap spreads have been
positive with the exception of the
30-year term and during periodic
market disruptions. In September
2015, the 10-year swap spread
turned negative, and today, all swap
spreads with a tenor of 5 years and
greater are negative. In theory, this
implies that the financial strength
of banks is greater than that of the
U.S. government and that the funding
costs of banks are lower than the
U.S. Treasury. However, in practice,
that has not been the case for term
borrowings. This phenomenon of
negative swap spreads may provide
end users the ability to borrow
floating and pay fixed on swaps,
thereby obtaining a comparative
advantage in funding costs.
PNC’s Derivative Products Group
(DPG) has been fielding questions
from our clients and relationship
managers asking why negative
swap spreads are continuing and
the impact it may have on market
participants. This article is an effort
to provide that explanation.
Why are Swap Spreads Negative?
Following the financial crisis and the
failure of Lehman Brothers, swap
contracts were reevaluated based
on the viability of counterparties.
Swap rates for the over-the-counter
(non-cleared) swaps market
experienced tremendous volatility.
Swap spreads in general widened as
market participants put premiums
on counterparty risk. But in the latter
half of 2008, the 30-year swap spread
dropped and quickly turned negative.
Many market events contributed to
the 30-year spread remaining below
zero without significant fanfare. It
wasn’t until last September when the
10-year swap spread decidedly dipped
below zero that many turned their
attention towards the swap spreads
market. This downward movement by
the more popular 10-year swap rate
has been slowly occurring and is a
result of a structural change in the
marketplace.
In a surprise move in August 2015, the
People’s Bank of China (PBoC) cut its
benchmark lending rate and reserve
ratio requirements to spur growth as
it transitions from a manufacturing
economy to a service economy. To
support its declining currency, the
Chinese central bank sold U.S.
Treasuries. With prices of Treasuries
moving lower and yields moving
higher, swap spreads narrowed. As
a result, the 10-year swap spread
moved negative. In addition to the
PBoC, a number of other foreign
central banks have sold U.S.
Treasuries in an attempt to support
their currencies. The large outflow
of foreign exchange (FX) reserves put
Treasuries under pressure versus
swaps, thus narrowing the swap
spread. During this period, dealer
treasury holdings increased to four
times the average.
As central banks sell U.S. Treasuries,
primary dealers have increased their
holdings of U.S. Treasuries. Treasuries
are funded assets, and dealers take
inventory and finance their holdings
at repo rates by using short-term
repurchase agreements. Repo rates
have risen much faster than other
short term borrowing rates (including
LIBOR) due to the rise in demand.
A jump in repo rates versus LIBOR
has narrowed swap spreads.
Another factor contributing to the
narrowing of swap spreads is mortgage-
related paying. A fundamental driver
of support for swap spreads has
abated as Government Sponsored
Enterprises (i.e., Fannie Mae, Freddie
Mac) portfolios have decreased in
size. In addition, the Federal Reserve
Bank, which does not hedge its
portfolio, is the single largest holder of
agency mortgage-backed securities.
Today, mortgage hedgers are much
less active, removing an important
source of pay-fixed swap demand
from the market.
The continued strong sales of
corporate bonds by issuers has also
contributed to negative swap spreads.
With corporations holding large
amounts of cash on their balance
sheets, companies are swapping
their fixed rate bond issuances back
to floating rates through an interest
rate swap under which companies
receive fixed rates and pay floating
rates (usually LIBOR). This puts
downward pressure on swap rates
and thus swap spreads. This has
allowed companies to lock in long
term liquidity and pay a floating rate
on their debt. The floating rate risk is
somewhat mitigated by the floating
rate of interest received on cash.

SWAP SPREAD ANALYTICS

The large outflow of foreign exchange (FX)
Tenor Current Level 1 Year Average 5 Year Average
reserves by foreign central banks puts
5 Year (4.60) 1.59 15.49 Treasuries under pressure versus swaps,
7 Year (14.95) (6.95) 11.31 thus narrowing the swap spread.
10 Year (13.00) (4.70) 8.90
Data as of May 17, 2016
Source: Bloomberg 3
 Perhaps the most notable reason
for negative swap spreads has
been regulation. The regulatory
requirement for central clearing of
most interest rate swaps (except for
swaps with commercial end users)
has removed counterparty risk from
such swap contracts. Regulatory
hedging costs and balance sheet
constraints have also come into
effect over the past few years. These
rules have significantly reduced
the market-making activity of swap
dealers and increased the cost of
leverage for such dealers. This is
evidenced in the repo rates versus
the Overnight Interest Swap2 (OIS)
basis widening. This basis widening
strips rate expectations (OIS) from
the pure funding premium (repo)
rates. Swaps and Treasuries are
less connected than in the past. The
spread between them is a reflection
of the relative demand for securities,
which need to be financed, versus
derivatives, which do not.
Expectations and Market
Opportunities
Going forward, we expect the
negative swap spreads to stabilize
with the bias toward moving wider
(less negative). Some of the factors
that contribute to this include the
slowing of U.S. Treasury sales
coming out of China. Data released
recently showed that China’s
FX reserves increased for the
first time since last October. An
additional factor for this has been
the significant decline in net primary
dealer positions in U.S. Treasuries,
which has typically spiked during
periods in which Chinese reserves
were declining. Therefore, the
demand for Treasuries from foreign
accounts seeking yield, coupled
with a reduction in sales from
China, should support cash yields
versus swaps. Additionally, recent
softness in repo rates has pushed
the spread to LIBOR to its widest
level since year-end. Lastly, with the
current low level of interest rates,
there hasn’t been a strong desire
for bond issuers to hedge, reducing
the demand for issuance-related,
receive-fixed swaps. All of these
factors would have the effect of
pushing swap spreads wider (less
negative) from their current levels.
Current negative swap spreads
present an opportunity for market
participants favoring fixed rate debt.
The bank markets traditionally price
over LIBOR, and the bond markets
price over Treasuries. By electing
to pay a fixed swap rate, a market
participant enjoys the benefit of
negative swap spreads through a
lower swap rate paid for the life of
the contract. Conditions are such
that accessing the bank market on a
floating rate basis and paying a fixed
swap rate may present a lower rate
than the bond markets.

ABOUT THE AUTHORS

Tina Hwang, Senior Vice President, Managing Director, PNC’s Derivative Products Group — Tina Hwang is a Senior Vice President and Managing
Director of PNC Capital Markets. In her position, she serves as regional manager for the northeast and mid-Atlantic territories for PNC’s Derivative
Products group. Hwang and her teams in Philadelphia, Washington, D.C. and Baltimore address the risk management needs of PNC Bank’s
customers, working collaboratively to properly identify, structure and execute interest rate and currency swaps across multiple lines of business.
She has more than 28 years of experience in the financial industry. Prior to joining PNC, she worked for a number of major banks and securities
companies, specializing in derivatives and other financial products. She has lived in Seoul, Korea and Osaka, Japan and currently lives in Media, Pa.
She holds bachelor of arts degrees in economics and East Asian studies from Dickinson College. She is a member of the local chapter of the PNC
Foundation, and a board member of Elwyn Corporation, a nonprofit organization that serves the needs of individuals with disabilities.
Vickie DeTorre, Managing Director, PNC’s Derivative Products Group — Vickie DeTorre is primarily responsible for managing PNC’s customer
derivatives portfolio, which includes pricing and executing various derivative transactions and managing the risks associated with those
transactions. She works closely with the derivatives sales force to develop interest rate hedging strategies for PNC’s customers. Vickie joined PNC
in January 1997. Prior to joining PNC, Vickie spent eight years with the Rate Risk Management Group at another major bank. She holds a bachelor’s
degree in business/accounting from the University of Pittsburgh and has obtained her Series 7 and Series 63 licenses.

READY TO HELP
At PNC, we combine a wider range of financial resources with a deeper understanding of your business to help
you achieve your goals. Should you have questions regarding the article or the strategy, please reach out to your
Derivative Products group marketer.

1 Interest rate swaps are contracts whereby two counterparties agree to exchange interest rates based on an agreed notional amount and maturity. Generally, one counterparty pays a fixed rate
while the other counterparty pays a floating rate, usually LIBOR. LIBOR stands for the London Interbank Offered Rate (LIBOR) and has a credit premium to comparable short term treasury bills.
2 The LIBOR-OIS Spread: The difference between LIBOR and OIS is called the LIBOR-OIS Spread and is deemed to be the health taking into consideration risk and liquidity.
(An Overnight Index Swap (OIS) is a swap where the floating payments are based on the overnight Federal Funds Rate.)
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