Swap Spread Seasonality Being Upended by Dollar Funding Pressure

  • Rise in Libor versus fed funds weighs on narrowing trend
  • Spreads remain wide even with corporate issuance climbing

Debt traders are running for the exits as the prospect of dollar-funding pressure surfaces in money markets and hinders the seasonal narrowing of swap spreads.

While issuance of U.S. investment-grade debt has been robust as usual at the start of the year and companies are following the standard playbook of also transforming those fixed-rate liabilities with swaps, spreads haven’t moved as anticipated. That appears to be because what banks pay to fund themselves relative to risk-less rates has expanded, a counter force for spreads.

“It is very odd,” said Priya Misra, head of global rate strategy at TD Securities in New York. “A lot of this can be attributed to the rise in Libor. Also a decline in rates has been led by Treasuries amid short-covering, given no new stream of news from the Trump team on tax reforms or fiscal spending.”

The swap spread represents the difference between the rate on an interest-rate swap and yield on a similar maturity Treasury.

Issuance of U.S. investment-grade corporate debt reached almost $60 billion last week alone, rebounding from a lackluster fourth quarter where just $116 billion was sold in November and December combined. Analysts are expecting as much as $110 billion in high-grade corporate bond sales in January.

Companies that issue bonds, which carry fixed-rate payment obligations, sometimes subsequently enter into swap agreements to receive fixed-rate payments and pay floating, a maneuver that typically drives swap rates lower and helps narrow spreads.

After stabilizing in the final week of last year, the dollar London interbank offered rate has resumed its rise. Libor surged in 2016 ahead of the October implementation of the U.S. Securities and Exchange Commission rules designed to safeguard the money-fund industry. That sparked a $1 trillion exodus from prime money market mutual funds -- an important source of short-term funding for banks and companies -- as they were among the types that were forced to abandon a fixed $1-per-share price.

“So far, I’m not seeing the usual other signs of funding pressure,” said Misra.

But more importantly for swap spreads, the pace of Libor’s rise has outstripped that of overnight index swaps, which gauge the outlook for the Federal Funds rate. That spread, known as Libor/OIS, trading in the forward market shows traders see the trend continuing. This gap, dubbed the FRA/OIS spread, almost reached 35 basis points Thursday, up from 30 at the end of last year. The spread reached 46 basis points in August amid the run up to the money-market reform.

“If the spread crosses 35 again, then I will get nervous and the broader market will start talking about a real funding issue going on.” Misra said.

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