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Interest-rate swaps have become an integral part of the fixed-income market. These derivative contracts, which typically exchange – or swap – fixed-rate interest payments for floating-rate interest payments, are an essential tool for investors who use them to hedge, speculate, and manage risk.
This article aims to explain why swaps have become so important to the bond market. It begins with a basic definition of interest-rate swaps, outlines their characteristics and compares them with more familiar instruments, such as loans. Later, we examine the swap curve, some of the uses of swaps, and the risks associated with them.
What is a Swap?An interest rate swap is an agreement between two parties to exchange one stream of interest payments for another, over a set period of time. Swaps are derivative contracts and trade over-the-counter.
The most commonly traded and most liquid interest rate swaps are known as “vanilla” swaps, which exchange fixed-rate payments for floating-rate payments based on LIBOR, the interest rate high-credit quality banks (AA-rated or above) charge one another for short-term financing. LIBOR, “The London Inter-Bank Offered Rate,” is the benchmark for floating short-term interest rates and is set daily.) Although there are other types of interest rate swaps, such as those that trade one floating rate for another, plain vanilla swaps comprise the vast majority of the market.
By convention, each participant in a vanilla swap transaction is known by its relation to the fixed rate stream of payments. The party that elects to receive a fixed rate and pay floating is the “receiver,” and the party that receives floating in exchange for fixed is the “payer.” Both the receiver and the payer are known as “counterparties” in the swap transaction.
Investment and commercial banks with strong credit ratings are swap market-makers, offering both fixed and floating-rate cash flows to their clients. The counterparties in a typical swap transaction are a corporation, a bank or an investor on one side (the bank client) and an investment or commercial bank on the other side. After a bank executes a swap, it usually offsets the swap through an interdealer broker and retains a fee for setting up the original swap. If a swap transaction is large, the interdealer broker may arrange to sell it to a number of counterparties, and the risk of the swap becomes more widely dispersed. This is how banks that provide swaps routinely shed the risk, or interest-rate exposure, associated with them.
Initially, interest rate swaps helped corporations manage their floating-rate debt liabilities by allowing them to pay fixed rates, and receive floating-rate payments. In this way, corporations could lock into paying the prevailing fixed rate and receive payments that matched their floating-rate debt. (Some corporations did the opposite – paid floating and received fixed – to match their assets or liabilities.) However, because swaps reflect the market’s expectations for interest rates in the future, swaps also became an attractive tool for other fixed-income market participants, including speculators, investors and banks.
As a result, the swap market has grown immensely in the past 20 years or so; the notional dollar value of outstanding interest rate swaps globally was $230 trillion at the end of 2006, according to the Bank for International Settlements. Swap volume is termed “notional” because principal amounts, although included in total swap volume, are never actually exchanged. Only interest payments change hands in a swap, as described below.
Characteristics of Interest Rate SwapsThe “swap rate” is the fixed interest rate that the receiver demands in exchange for the uncertainty of having to pay the short-term LIBOR (floating) rate over time. At any given time, the market’s forecast of what LIBOR will be in the future is reflected in the forward LIBOR curve.
At the time of the swap agreement, the total value of the swap’s fixed rate flows will be equal to the value of expected floating rate payments implied by the forward LIBOR curve. As forward expectations for LIBOR change, so will the fixed rate that investors demand to enter into new swaps. Swaps are typically quoted in this fixed rate, or alternatively in the “swap spread,” which is the difference between the swap rate and the U.S. Treasury bond yield (or equivalent local government bond yield for non-U.S. swaps) for the same maturity. Swap spreads are discussed in more detail in the next section.
In many ways, interest rate swaps resemble other familiar forms of financial transactions, and it is helpful to think of swaps in these terms:
The Swap CurveThe plot of swap rates across all available maturities is known as the swap curve, as shown in the chart below. Because swap rates incorporate a snapshot of the forward expectations for LIBOR and also reflect the market’s perception of credit quality of these AA-rated banks, the swap curve is an extremely important interest rate benchmark.
Although the swap curve is typically similar in shape to the Treasury yield curve, outright swap rates are generally higher than Treasury yields with corresponding maturities, as the chart above illustrates. This premium, or “swap spread” at any given maturity, mostly reflects the incremental credit risk associated with the banks that provide swaps compared to Treasuries, which are viewed as risk-free. While the swap spread can be also be driven by short-term supply and demand fundamentals and other factors within the swap market, the overall level of swap spreads across maturities can also offer a broad reading of the creditworthiness of the major banks that provide swaps.
Because the swap curve reflects both LIBOR expectations and bank credit, then, it is a powerful indicator of conditions in the fixed income markets. In certain cases, the swap curve has supplanted the Treasury curve as the primary benchmark for pricing and trading corporate bonds, loans and mortgages.
Uses for SwapsInterest rate swaps became an essential tool for many types of investors, as well as corporate treasurers, risk managers and banks, because they have so many potential uses. These include:
Risks Associated with Interest Rate SwapsLike most non-government fixed income investments, interest-rate swaps involve two primary risks: interest rate risk and credit risk, which is known in the swaps market as counterparty risk.
Because actual interest rate movements do not always match expectations, swaps entail interest-rate risk. Put simply, a receiver (the counterparty receiving a fixed-rate payment stream) profits if interest rates fall and loses if interest rates rise. Conversely, the payer (the counterparty paying fixed) profits if rates rise and loses if rates fall.
At the time a swap contract is put into place, it is typically considered “at the money,” meaning that the total value of fixed interest-rate cash flows over the life of the swap is exactly equal to the expected value of floating interest-rate cash flows. In the example shown in the graph below, an investor has elected to receive fixed in a swap contract. If the forward LIBOR curve, or floating-rate curve, is correct, the 5.5% he receives will initially be better than the current floating 4% LIBOR rate, but after some time, his fixed 5.5% will be lower than the floating rate. At the inception of the swap, the “net present value,” or sum of expected profits and losses, should add up to zero.
Sample for illustrative purposes only.
However, the forward LIBOR curve changes constantly. Over time, as interest rates implied by the curve change and as credit spreads fluctuate, the balance between the gray zone and the blue zone will shift. If interest rates fall or stay lower than expected, the “receiver” of fixed will profit (gray area will expand relative to blue). If rates rise and hold higher than expected, the “receiver” will lose (blue expands relative to gray).
If a swap becomes unprofitable or if a counterparty wishes to shed the interest rate risk of the swap, that counterparty can set up a countervailing swap – essentially a mirror image of the original swap – with a different counterparty to “cancel out” the impact of the original swap. For example, a receiver could set up a countervailing swap in which he pays the fixed rate.
Swaps are also subject to the counterparty’s credit risk: the chance that the other party in the contract will default on its responsibility. Although this risk is very low – banks that deal in LIBOR and interest rate swaps generally have very high credit ratings of double-A or above – it is still higher than that of a risk-free U.S. Treasury bond.
ConclusionThe interest rate swaps market started decades ago as a way for corporations to manage their debt and has since grown into one of the most useful and liquid derivatives markets in the world. Vanilla swaps, which are most common and involve the exchange of floating-rate LIBOR for a fixed interest rate, are used across the fixed-income markets to manage risks, speculate, manage duration and lock in interest rates.
Because swaps are highly liquid and have built-in forward rate expectations as well as a credit component, the swap rate curve has become an important interest-rate benchmark for credit markets that in some cases has supplanted the U.S. Treasury yield curve.
Past performance is not a guarantee or a reliable indicator of future results. Each sector of the bond market entails risk. Municipals may realize gains and may incur a tax liability from time to time. The guarantee on Treasuries, TIPS and Government Bonds is to the timely repayment of principal and interest; shares of a portfolio that invest in them are not guaranteed. Mortgage-backed securities are subject prepayment risk. With corporate bonds, there is no assurance that issuers will meet their obligations. An investment in high-yield securities generally involves greater risk to principal than an investment in higher-rated bonds. Investing in non-U.S. securities may entail risk because of non-U.S. economic and political developments, which may be enhanced when investing in emerging markets.
Swaps are a type of derivative in which a privately negotiated agreement between two parties takes place to exchange or swap investment cash flows or assets at specified intervals in the future. There is no central exchange or market for swap transactions and therefore they are less liquid than exchange-traded instruments.
LIBOR (London Interbank Offering Rate) is the rate banks charge each other for short-term Eurodollar loans.
This article contains the current opinions of the manager and does not represent a recommendation of any particular security, strategy or investment product. Such opinions are subject to change without notice. This article is distributed for informational purposes only. Information contained herein is from sources believed reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2014, PIMCO.
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