Swap spreads bulged to historically wide levels last week, propelled by what dealers are calling a revolution in their market as investment banks and money managers increase their use of swaps as a hedge for credit risk.
"Swap spreads have been wider than we've seen in many years, and I suspect that they could go wider in this kind of environment," said David Montano, a director of mortgage research at Credit Suisse First Boston. "They are wider than they were in October of '98, and they will go wider, especially if there is a tightening or further inflationary information coming to the market."
Additionally, fixed-income syndicate desks, once minor characters in swaps, have become "significant players" over the past six months as Wall Street firms and their clients turn to swap spreads to hedge inventories of highly rated corporate, agency and mortgage securities.
As a result, the spreads have become much more closely tied to movements in those markets like the recent downturn in corporate bonds, which helped push swap spreads to levels wider than those reached at the depths of last year's liquidity crisis.
Compared with October 1998, swap spreads are between five basis points and six basis points wider on the 10-year bond, Montano said, but not quite as wide on the five-year.
This past week, swaps have been extremely directional with the 10-year Treasury, market sources said. On the week, they were wider by about six basis points.
"There's been a supply and demand imbalance in spread product generally," said Art Frank, head of mortgage research for Nomura Securities. As this imbalance causes prices to fall on agency debt, mortgage-backed securities and corporate bonds that have been hedged with swaps, the one-way flows have pressured swap spreads to an extent never before seen in the market.
"Now, swapping something from fixed to floating is a lot more expensive than it was," said the head of one MBS shop. "It has also gotten much more expensive for the agencies to issue debt.
"Agency debt levels have really suffered here, and that impacts their ability to buy collateral, and collateralized mortgage obligations."
Swap spreads did begin to rebound slightly on Wednesday, narrowing by about five basis points by mid-day. But in another example of the market's new dynamics, a single Wall Street firm executed a series of trades totaling $3 billion, pushing the market back two to three basis points. Swaps pros suggested Thursday that the firm was probably looking to swap fixed-rate for floating in order to hedge spread risk for a major institutional client.
Ten-year swap spreads, therefore, firmed up only briefly last week. Though spreads have gotten as wide as 100 bps recently, they were probably closer 96 or 97 last week, market sources noted.
"Swaps are a fairly liquid benchmark for spread product," said Nomura's Frank. "On-the-run Treasurys are on special a lot in the repo market, so they're not as good a benchmark. [Swaps are becoming] a benchmark for the higher end of the credit market." But as swap spreads widen, he added, "corporates and mortgages have to follow or they'll become cheap."
- AT/Jeffrey Keegan/Christopher O'Leary