Recent distortions in interest rate derivative markets have sparked a radical notion in the world of fixed income—the idea that so-called swap rates could replace U.S. Treasury yields as the benchmark risk-free borrowing rate in securities markets.
Harley Bassman, portfolio manager at Pacific Investment Management Co., is the most prominent voice to float the idea after swap rates last year dipped below equivalent U.S. Treasury yields across a range of maturities.
"Major transitions are frequently met with slack-jawed disbelief, until it becomes obvious," Bassman writes in his discussion of an admittedly extreme idea. "A thoughtful investment management process should at least evaluate–even try to hang a price upon–the potential, however slim, for such a major transition."
So-called negative swap spreads had been a rarity in financial markets, as they represent an inversion of traditional market assumptions that dictate borrowing costs linked to banks should be higher than what the U.S. government pays to borrow.
Negative swap spreads have been much discussed by analysts and investors in recent months, with many blaming the inversion on new financial regulation that makes it more expensive for banks to trade and hold U.S. government debt on their balance sheets. Meanwhile, mandatory central clearing of interest rate swaps is said to have eliminated "counterparty risk" from the contracts, thereby rendering them theoretically riskless and leaving them with a minimal funding component when compared with Treasuries.
Pimco's Bassman argues that interest rate swaps could prove the better choice for a risk-free benchmark, given they do not require significant amounts of balance sheet, among other things:
But just because a UST [U.S. Treasury] is a perceived nearly “risk-free” asset does not automatically make it the superior benchmark. USTs are issued in a fixed quantity with a single CUSIP; a derivative IRS [interest rate swap] has no such limitations. USTs demand a place to be stored (balance sheet), while IRSs do not. USTs have a huge terminal principal that must be safeguarded in case of financing counterparty default; IRSs have only a rate differential at risk. This concept also affects investors in currencies other than the U.S. dollar since currency movements can have a greater impact on principal than mark-to-market value movements.
While one may debate which is more liquid, there is no questioning the efficiency of the swap market. Buying and selling large notional IRSs requires little preparation–they can be bought or sold in any size, at any time. In contrast, selling short a single CUSIP UST security can have both a large and uncertain cost, and their availability can vary widely. As such, the analysis of the interest rate term structure is almost solely the purview of the IRS market since UST long-term funding (the cost to borrow a single CUSIP) is relatively rare.
There are potential spanners here, not least of which is the fact that swap rates remain linked to the interbank lending rate known as Libor. Readers may remember Libor from such news stories as this, this, or this, though Bassman argues that an international interbank lending rate independent of the Federal Reserve may hold global appeal. Meanwhile, it's far from certain that any bank is even considering making what would be a substantial leap in benchmark rates when structuring an actual securities deal, or even how it might do so.
Still, the notion is not without its supporters.
"UST rates have a funding component, swaps do not," Richard MacWilliams, a managing partner at Vista Capital Advisors in New York, said in a note late last year. "In a world of centrally cleared swaps, one could argue the true benchmark for a credit-free and funding-free interest rate is not U.S. Treasuries but rather a centrally cleared swap."
Head over here to read the full Pimco piece.